Capital Market

An increase in short-term interest rates may increase or decrease the value of the domestic currency.

Higher interest rates generally attract capital and increase the domestic currency value. At some level though, higher interest rates will result in lower currency values because the high rates may stifle an economy abd make it less attractive to invest there

U.S. TIPS are protected against increases in inflation. They would be needed the least when inflation is falling. During the initial recovery phase of the business cycle, the inflation is falling.

The analyst needs to understand the definition, construction, timeliness, and accuracy of any data used, including any biases. The time lag with which economic data are collected, processed, and disseminated can be an impediment to their use.
Furthermore, one or more official revisions to the initial values are common.
Definitions and calculation methods change too.
Suppliers of indices of economic and financial data periodically re-base these indices, meaning that the specific time period used as the base of the index is changed.

After the initial recovery period, confidence is up and the economy is gaining some momentum. This is the healthiest period of the cycle, in a sense, because economic growth can be robust without any signs of overheating or sharply higher inflation. Typically, there is increasing confidence, with consumers prepared to borrow and spend more as unemployment starts to fall. Concurrently, businesses build inventories and step up investment in the face of strong sales and increased capacity use. Higher operating levels allow many businesses to enjoy lower unit costs, so that profits rise rapidly.

A key question is how long it will take before inflation starts to become a problem. Short rates are moving up at this time as the central bank starts to withdraw the stimulus put in place during the recession. Longer bond yields are likely to be stable or rising slightly. Stocks are still trending up. This phase usually lasts at least a year and often several years if growth is not too strong and the output gap closes slowly.

A recession is conventionally defined as two successive quarterly declines in GDP. There is often a large inventory pullback and sometimes a large decline in business investment. Consumer spending on big-ticket items such as cars usually declines (although the US 2001 recession was an exception). Once the recession is confirmed, central banks ease monetary policy, but only cautiously at first. Recessions typically last six months to a year. Both consumer and business confidence decline. Profits drop sharply. In a severe recession, the financial system may be stressed by bad debts, making lenders extremely cautious. Often, recessions are punctuated by major bankruptcies, incidents of uncovered fraud, or a financial crisis. Unemployment can rise quickly, putting downward pressure on inflation.

There are four broad approaches to forecasting exchange rates, and most forecasters probably use a combination of them all:

Purchasing Power Parity
Relative Economic Strength
Capital Flows
Savings–Investment Imbalances

Quantitative models such as equilibrium models offer the prospect of providing a non-emotional, objective rationale for a forecast. The expectations-setting process nevertheless can give wide scope to applying judgment—in particular, economic and psychological insight—to improve forecasts. In forecasting, numbers, including those produced by elaborate quantitative models, must be evaluated.
Other investors who rely on judgment in setting capital market expectations may discipline the process by the use of devices such as checklists.

Nominal default-free bonds are conventional bonds that have no (or minimal) default risk.
For investors buying and selling long-term bonds over a shorter time period, the emphasis is on how bond yields will respond to developments in the business cycle and changes in short-term interest rates.
As bond investors look toward the long-term picture, they must carefully assess the future effects of inflation, which erodes the future purchasing power of the yields earned on their fixed-income investments.

Once interest rates are at zero, further monetary stimulus requires new types of measures.

First, the central bank can push cash (bank “reserves”) directly into the banking system.
A second possibility is to devalue the currency.
The third option is to promise to hold short-term interest rates low for an extended period.
The final option is for the central bank to buy assets directly from the private sector.

The illiquidity premium for an alternative investment should be positively related to the length of the investment’s lockup period or illiquidity horizon. How can the amount of the illiquidity premium be estimated? One estimation approach uses the investment’s multiperiod Sharpe ratio (MPSR), which is based on the investment’s multiperiod wealth in excess of the wealth generated by the risk-free investment (i.e., compounded return over compounded cash return).
There would be no incentive to invest in an illiquid alternative investment unless its MPSR—its risk-adjusted wealth—were at least as high as the MPSR of the market portfolio at the end of the lockup period.

Countries with tighter monetary policy and stronger economic growth will see higher currency values. In fact, in the early 1980s, the U.S. had high real and nominal interest rates due to a tight monetary policym robust economy, and an increasing budget deficit. This resulted in a higher value of the dollar.

The balance of payments (an accounting of all cash flows between residents and nonresidents of a country) consists of:
the current account, dominated by the trade balance (reflecting exports and imports), and
the financial account, consisting of portfolio flows (from security purchases and sales—e.g., bonds and equities) and foreign direct investment (FDI) by companies (e.g., Toyota Motor Corporation building an automobile assembly plant in the United States), as well as flows such as borrowing from and deposits with foreign banks.
The sum of the current account and the financial account, or the overall trade balance, should be zero.

The analyst usually encounters at least two kinds of uncertainty in conducting an analysis: model uncertainty (uncertainty concerning whether a selected model is correct) and input uncertainty (uncertainty concerning whether the inputs are correct).
Input uncertainty and model uncertainty in particular often make it hard to confirm the existence of capital market anomalies (inefficiencies); some valuation model usually underlies the identification of an inefficiency. Behavioral finance (the theory that psychological variables affect and often distort individuals’ investment decision making) has offered explanations for many perceived capital market anomalies.

If fiscal and monetary policies are both tight, then the situation is unambiguous and the economy is certain to slow. Similarly, if both monetary policy and fiscal policy are expansionary, then the economy can be expected to grow.
Policy Mix and the Yield Curve:

Monetary & Fiscal/ Loose & Loose: Yield curve steep
Monetary & Fiscal/ Tight & Loose: Yield curve flat
Monetary & Fiscal/ Loose & Tight: Yield curve moderately steep
Monetary & Fiscal/ Tight & Tight: Yield curve inverted

During a recession, with falling inflation and interest rates, bonds generally post capital gains.
Inflation at or below expectations:
Yield levels maintained; market in equilibrium. [Neutral]
Inflation above expectations:
Bias toward higher yields due to a higher inflation premium. [Negative]
Deflation:
Purchasing power increasing. Bias toward steady to lower rates (may be offset by increased risk of potential defaults due to falling asset prices). [Positive]

According to elementary portfolio theory, the correlation between two assets is given by β1β2σ2M/σ1σ2

Low inflation can be benefitial for equities if there are prospects for economic growth free of central bank interference
Declining inflation ususally results in declining economic growth and asset pricies
The firms most affected are those that are highly leveraged because they are most sensetive to changing interest rates
Low inflation does not affect the return on cash instruments

Shrinkage estimation involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, where the weights reflect the analyst’s relative belief in the estimates.
The term “shrinkage” refers to the approach’s ability to reduce the impact of extreme values in historical estimates. The procedure has been applied to covariances and mean returns.
A shrinkage estimator of the covariance matrix is a weighted average of the historical covariance matrix and another, alternative estimator of the covariance matrix, where the analyst places the larger weight on the covariance matrix he or she believes more strongly in.
A shrinkage estimator approach involves selecting an alternative estimator of the covariance matrix, called a target covariance matrix.

Statistical methods relevant to expectations setting include descriptive statistics (methods for effectively summarizing data to describe important aspects of a dataset) and inferential statistics (methods for making estimates or forecasts about a larger group from a smaller group actually observed).

The risk premium approach expresses the expected return on a risky asset as the sum of the risk-free rate of interest and one or more risk premiums that compensate investors for the risky asset’s exposure to sources of priced risk (risk for which investors demand compensation).
The risk premium approach (sometimes called the build-up approach) is most often applied to estimating the required return in equity and bond markets.

Data on business investment and spending on inventories reveal recent business activity. As already mentioned, both tend to be relatively volatile so that it is not uncommon for business investment to fall by 10–20 percent or more during a recession and to increase by a similar amount during strong economic upswings.

Economists and the markets have been skeptical about whether governments really can control exchange rates with market intervention alone because of three factors.
First, the total value of foreign exchange trading, in excess of US$1 trillion daily, is large relative to the total foreign exchange reserves of the major central banks combined.
Second, many people believe that market prices are determined by fundamentals and that government authorities are just another player.
Third, experience with trying to control foreign exchange trends is not encouraging in the absence of capital controls.

Time-series estimators involve forecasting a variable on the basis of lagged values of the variable being forecast and often lagged values of other selected variables.
Time-series methods have been found useful in developing particularly short-term forecasts for financial and economic variables. Time-series methods have been notably applied to estimating near-term volatility, given persuasive evidence of variance clustering (particularly at high frequencies, such as daily and weekly) in a number of different markets.
Volatility clustering is the tendency for large (small) swings in prices to be followed by large (small) swings of random direction. Volatility clustering captures the idea that some markets represent periods of notably high or low volatility.

If the number of asset classes is n, the analyst will need to estimate (n2 − n)/2 distinct correlations (or the same number of distinct covariances)