Forecasting Equity Returns | cfa level 3 notes
LOS-discuss approaches to setting expectations for equity investment market returns
discuss risks faced by investors in emerging market equity securities
Forecasting Equity Returns:
Notes:
Singer–Terhaar model Example:
Suppose that an investor has developed the following projections for German shares and bonds.The risk-free rate is 1.0%, and the investor’s estimate of the global Sharpe ratio is 0.30.
The following are the fully integrated risk premiums for each of the assets :
Equities: 0.70 × 17.0% × 0.30 = 3.57%.
Bonds: 0.50 × 7.0% × 0.30 = 1.05%.
The following are the fully segmented risk premiums :
Equities: 17.0% × 0.35 = 5.95%.
Bonds: 7.0% × 0.25 = 1.75%.
Based on 85% integration (φ = 0.85), the final risk estimates would be as follows:
Equities: (0.85 × 3.57%) + (1 − 0.85) × 5.95% = 3.93%.
Bonds: (0.85 × 1.05%) + (1 − 0.85) × 1.75% = 1.16%.
Adding in the risk-free rate, the expected returns for German shares and bonds would be 4.93% and 42.16%, respectively.
The risks of investing in emerging market equities:
-Emerging markets tend to have more fragile economies, less stable political and policy frameworks, weaker legal protections, and lower degrees of informational efficiency compared to developed markets. This can lead to higher volatility and uncertainty.
-Country-specific risks tend to outweigh industry-specific risks in emerging markets, given their lower levels of global economic and market integration. Local economic and political factors have an outsized influence.
-Weak corporate governance, accounting standards, disclosure rules, and property rights can disadvantage equity investors via issues like insider manipulation, lack of transparency, nationalization of assets, and unpredictable regulation.
-Beyond traditional credit risks, equity investors in emerging markets also need to evaluate risks related to corporate governance, property rights, nationalization, and unpredictable regulation, especially during periods of macro and political distress.
-Emerging markets are highly heterogeneous, so risks vary significantly across countries. It’s important to analyze each market individually.
In summary, emerging market equities tend to carry higher macroeconomic, political, and governance risks that equity investors must carefully evaluate before investing. But not all emerging markets are the same in terms of risks.
16 Jul 2023 - Original by toptradeready.com