Reading 23.

Forecasting Market Expecations

I. What are Capital Market Expectations (CME)

1. Risk/return expectations about asset classes – macro expectations
i. Contrast with micro expectations – individual assets.
ii. Macros help frame micros.
2. Beta research – centralized CME related to systematic risks/returns. Centralization ensures
consistent assumptions
3. Alpha research – how to capture excess returns through particular strategies. Conducted by
specialized groups with requisite knowledge/experience.
II. Developing CME
1. Specify objectives  what do you need to know? (time horizon , pre-tax or after tax?)
2. Research historical records  useful information on investment characteristics and the
factors that affect them.
3. Determine the models & methods to be used and their requirements.
4. Locate the best source of the needed information.
5. Interpret the current investment environment applying judgment & experience  make
sure your assumptions are consistent.
6. Answer your objectives set in #1
7. Monitor the outcome of your forecast.
III. CME in Practice
1. Match data series to relevant analysis – quarterly/annual data for long term CME, daily for
short term.
2. Top-down approaches to CME use more economics than bottom up.
3. Internal inconsistency is important. i.e. don’t use different inflation expectations in your
equity and bond models. Check correlations for feasibility (3 assets cannot all be -1)
4. Ex post vs ex ante: Overlooking the effects of the risk of a negative event in the past on the
price movements and using those movements to predict future characteristics.
i. At the time, assets could be pricing in the probability of a significant event that
didn’t happen. Looking backward, we think return/risk relationship was superior
 than it really was. When the event didn’t happen returns surged, low volatility
because returns stayed low reflecting the risk of the negative event.
5. Be aware of limitations to economic data  lagged data releases, official revisions,
methodology changes.
i. Don’t mix data from two sides of a re-basing (mathematical recomputation of a data
series)
6. Potential data biases/errors:
i. Transcription errors: problems gathering & recording data
ii. Survivorship bias: e.g. HF indices. Data that reflects only entities that have survived
to the end of the period.
iii. Appraisal (smoothed) data: Private equity  prices not market driven but based
on estimates, typically less volatile. Results in lower correlations and standard
deviations.
a. Can adjust for this by rescaling the dispersion around the mean (same
mean, more volatility).
iv. Regime change & nonstationarity: The governing set of relationships changes,
resulting in different underlying statistical properties across a time series  think
fair market accounting rules.
a. Longer data series more likely to occur  sometimes adding more data
actually makes the data worse.
v. Asynchronism: discrepancy in the dating of observations that occurs because stale
data may be used in the absence of current data  problem with high-frequency
data.
7. Potential biases in methods:
i. Data mining bias: searching for patterns in data. Patterns themselves aren’t
meaningful, need theory behind it.
ii. Time period bias: Time period specific results, looked at by themselves, can distort
analysis. E.g.  small cap stocks outperformed from ’75-’83, looked at from ’26-’01
removing that period they haven’t.
a. Prevent by splitting data into sub-periods and seeing if patterns hold.
iii. Failure to condition information: Some patterns may hold in certain scenarios
 a. Think asset with a β = 1. Might be 1.2 in recession 0.8 in expansion. If
you’re in an expansion condition your information, use the 0.8 not the 1.
iv. Misinterpret correlation: Correlation <> causation. If A & B are correlated, A could
predict B, B could predict A, or C could predict A & B.
a. Non linear relationships too  B = A2 would show no correlation but strong
predictive relationship.
8. Traps in CME
i. Anchoring trap: giving disproportionate weight to first information received.
ii. Status quo trap: forecast perpetuation of recent observations.
iii. Confirming evidence trap: giving greater weight to POV supporting info.
iv. Overconfidence trap: overestimated forecasting ability
v. Prudence trap: tempering forecasts to not appear extreme, being overly cautious.
vi. Recallability trap: overly influenced by events that left a strong impression on you.
9. Input uncertainty (is the data in your model correct) and model uncertainty (are you using
the right model) make it difficult to confirm the existence of capital market anomalies.
10. Quant models provide non-emotional, objective rationale but must be improved with
judgment.
IV. Statistical Models in CME – using data to summarize an important aspect or forecast a larger group
from a smaller group
1. Historical statistical approach: Using historical sample estimators , such as the long run
mean equity return, to forecast. Requires stationary data (see above, no regime changes).
i. Arithmetic vs geometric mean  Arithmetic always used in calculating std, best for
single periods. Geometric best describes mutltiperiod growth and compounding.
Geometric always lower for risky variable.
2. Shrinkage estimation: Combination approach applying a weight to a sample estimator and
an alternative model, such as a factor model. Weights applied relative to confidence in
estimate. Use because time series include historical anomalies.
i. Book talks a lot about covariance matrices in this section.
ii. Shrinkage estimators always increase the efficiency of covariance estimates versus
the historical estimate.
3. Time-series estimators forecast a variable using a lagged value of that variable and perhaps
lagged values of other variables.
 i. Useful in short term forecasts. Volatility clustering is a common example
(large/small swings in prices followed by large/small swings of random direction).
a. One measure says volatility in period 2 is the weighted average of volatility
in period 1 times the rate of influence decay plus an error term times the
inverse of the rate of decay. Pp29
4. Multifactor Models: standard regression formula.
i. Useful in estimating covariance since variable’s factor sensitivities can be used to
derive the covariance.
ii. Using a top-down approach with multifactor models to estimate covariance
(described below is 2 layers, can have many layers): pp31
a. Create a factor covariance matrix (relationships between the factors that
drive returns for the asset markets you are trying to relate).
b. Determine the asset’s sensitivities to the factors.
c. Use factor variance, their covariance, and the asset’s sensativities to those
factors to create the asset covariance matrix.
d. Check for consistency. Multifactor models make this easy  major plus.
V. DCF Models in CME – Basic tool to establish fundamental value, does not incorporate
supply/demand conditions so a long-run tool not short-run.
1. Dividend discount models – typically used in equity markets. E(R) = D 1/P0 + g. Share price
appreciates with dividend growth.
i. Growth usually determined as nominal GDP + excess (deficit) corporate growth.
ii. Grinold-Kroner Model: Better DDM, incorporates share repurchases and valuation
changes. E(R) = E(D/P) + growth + inflation + %∆PE - %∆shares outstanding
a. Also segments returns into income (E(D/P)) and capital gains (the rest).
iii. Fed Model is an example of a DCF model thinking used to evaluate stock market
levels. Says if market yield < 10 yr Tbond yield the market is overvalued.
2. DCFs are the standard in fixed income markets.
i. The YTM of a reference instrument for a bond market segment is a readily available
first approximation of the market expected return for that asset segment in a time
horizon equal to the instrument’s maturity.
 a. Operates under the assumption that coupons can be reinvested at the YTM
 can create distortions. Best estimate is a representative zero-coupon
bond’s YTM.
VI. Risk Premium Approaches in CME (aka build up approach) – the expected return is the sum of the
risk free rate and 1+ risk premiums that compensate for the exposure to sources of priced risk (risk
investors demand return for).
To find the portfolio expected spread/premium over a reference: Find weighted average of all
premiums, subtract 1. Eg  33% weight to 3 securities w/ premiums 0, 2.7%, .95% = .
33(0)+.33(2.7%)+.33(.95%) ~ 1.22 – 1 = .22%.
1. Fixed income premiums:
i. Real risk free rate – in economics, time preferences of individuals for current vs
future consumption.
ii. Inflation premium – sum of inflation and real risk free = nominal risk free rate, often
represented by a government tbill YTM. Use inflation expectations not current if
given both (pp 111 #3)
iii. Default risk premium
iv. Illiquidity premium – risk of loss if asst must b converted into cash quickly
v. Maturity premium – compensates for increased sensitivity to interest rates.
vi. Tax premium (as applicable)
2. Equity premiums – compensates investors for being lower on the totem pole. In practice
specifically defined as the expected excess return over a long term government bond.
i. E(Re) = YTM of a long term government bond (10 or 20 years, most places only have
10) + equity risk premium
ii. Highly volatile.
VII. Financial Equilibrium Models – relationships between expected return and risk in which supply &
demand are in balance. Black-Litterman, ICAPM
1. ICAPM – domestic risk free rate + asset’s sensitivity to the global market risk (standard
CAPM calculations).
i. The global investible market (GIM) can be used as a proxy for the world market
portfolio, includes all asset classes with sufficient ability to absorb meaningful
investment.
 ii. Manipulating the equation (pp43), asset’s risk premium equals the product of the
GIM’s Sharpe ratio (RPM/σM, or excess return per unit of risk), asset’s σ, asset’s
correlation to the GIM, ρi,M or RPi = σi * ρi,M * (RPM/σM)
iii. σM cannot be diversified away, pure systematic risk.
iv. The covariance of two assets in ICAPM is equal β 1 X β2 X σ2M
a. β1 calculated as (σ1 X ρ1,M) / σM
2. Singer-Terhaar approach takes ICAPM and adds the impact of market segmentation and
illiquidity
i. Domestic markets fall somewhere between pure market integration and market
segmentation.
a. Market segmentation impedes capital movements between markets.
b. Perfect integration premium calculated just like ICAPM.
c. Perfect segmentation remove the correlation component ρi,M
ii. Estimate the degree of integration for a market and weight the above calculations,
sum the result, add the liquidity premium as appropriate, gives you’re the Singer-
Terhaar RP. Add the risk free rate and you get E(R i)
iii. The illiquidity premium for an alternative asset is directly related to its lockup.
a. Can be estimated with a multiperiod Sharpe Ratio (MPSR)
1) Investment’s multiperiod wealth in excess of that generated by the
risk free investment calculated over the lockup.
VIII. Survey/Panel Methods: Survey experts for expectations and use their responses to frame CME. If
stable set of experts it’s a panel.

Economic Analysis

I. Business Cycle Analysis

1. Business cycles are longer term, 9 – 11 years.

Phase Length Economy/Inventory Inflation Confidence Policy Bonds Equities

Initial Short, few Upswing in Inflation rebounding, low Fiscal & Bond yields still fall Stocks rise rapidly,
recovery months inventories, large declines with consumers monetary but bottoming. particularly cyclical.
output gap, bottoming (unemployment) stimulus Emerging does Emerging does well.
unemployment high well.
Early 1– Robust growth, Moderate, Increasing Withdrawing Short rates rising, Trending up
upswing several inventories and no worries stimulus long rates mostly
years capacity growing stable
Late Output gap closed, Rising High to bubble Monetary Rising yields, Still rising, volatility
upswing rapid growth, wage tightening to anxious bond sometimes high
growth w/ labor soften markets watching with nervousness
shortage landing monetary policy
Slowdown Few Slowing growth, Still rising Wavering Monetary Bonds top out then Falling, interest-
months to reducing inventories tightening yields fall sharply. sensitive stocks i.e.
a year exacerbate problems peaks Curve often inverts utils & fin best
Recession 6 months GDP Falls. Durables Downwar Drops rapidly Cautious Short rates and Begin rising near
to a year fall. Profits drop, fin d pressure easing bond yields fall. end.
system stressed, Outstanding bonds
employment falls rise sans defaults
i. 4 Factors affecting the business cycle:
a. Consumers: 60-70% of GDP in developed world, most important component
1) Consumption data often erratic m/m & affected by unusual events
2) Primary drivers: consumer AT income & unemployment
3) Increases in income translate to consumption in varying rates due to
changes in the savings rate  consumer confidence gives hints here
b. Businesses: Smaller component but more volatile than consumers.
1) Inventory common measure  noise here, inventories could grow
to meet forecasted demand or result from actual demand falling
2) Business surveys have also been very useful  US purchasing
managers index is a good example.
c. Foreign Trade: More important in smaller countries where it can be 30-50%
GDP; developed countries typically 10-15%.
d. Government Policy: Both monetary policy and fiscal policy are used to
influence the business cycle for three main reasons:
1) Mitigate severe recessions/moderate economic booms (bubbles)
2) Meet inflation targets
3) Politicians prefer to hold elections in upswings, may try to influence.
2. Inventory cycles are short term, 2-4 years
i. Up phase has business confident in the future, growing, increasing production.
ii. At some point disappointment, inventories get cut, production slows, growth slows.
a. Often trigger events  high commodity prices or tightened monetary policy
iii. Modern supply chain management has not eliminated this but moderated the size.
3. Output gap – difference between GDP and potential GDP. + output gap during recession,
reduces inflation pressure. Inflation pressure builds as output gap closes, inflationairy
environment when output is above trend.
 i. Real time forecasts historically inaccurate.
II. Inflation
1. Deflation large threat to economy
i. Undermines debt-financed investments – equity falls in a leveraged manner.
ii. Limits central bank activity (rates can only move up)
2. Gold standard held economies in deflation previously.
3. Maintaining inflation expectations keeps most markets at equilibrium and is generally
neutral. Exception is positive impact on equities.
i. Rising inflation is positive for cash and real estate, negative for bonds and equity.
ii. Deflation is negative for cash, real estate, and equity but positive for bonds.
4. Money supply long run stable relationship with nominal GDP growth  if money supply is
growing stronger than GDP, growth should accelerate near term and bring inflation.
III. Monetary Policy to affect Business Cycle: Manipulating money supply and interest rates
1. High unemployment & spare capacity allows for GDP growth above trend w/o overheating.
2. Will often slash rates and increase liquidity in the face of financial crisis in particular.
3. Key variables watched by monetary authorities:
i. GDP growth, excess capacity, unemployment, inflation
4. Current popular tool is setting short term interest rates. Lower rates will often:
i. Encourage more borrowing (both consumers & business) & increase asset prices
driving more spending and investment.
ii. Cause currency depreciation and boost international exports.
5. Not the change that matters but where rates are in relation to the “neutral rate”
i. Neutral rate is a theoretical rate that covers real risk free rate and inflation.
6. The Taylor Rule is often used to asses central bank’s stance and predict changes.
i. Roptimal = Rneutral + [ ½ (GDPgforecast – GDPgtrend) + ½ (Iforecast – Itarget)]
7. Central banks need to use alternative methods when rates hit zero, limiting their ability to
influence the markets. Hence targeting inflation >2% gives them flexibility. When zero:
i. Push reserves directly into banking system to increase lending
ii. Devalue currency
iii. Promise to hold rates low for extended period of time
iv. Buy assets directly from private sector, distributing money and lowering yields
IV. Fiscal Policy to affect Business Cycle: Manipulating the size of G by spending or taxes
 1. Changes matter here not level.
2. Deliberate changes matter, not “normal” cycle driven changes.

3. Fiscal and monetary policy interact to shape the yield curve:

Fiscal Policy
Monetary Policy

Loose Tight
Loose Steeply upward Moderate upward
Tight Flat Inverted

V. Growth Trends
1. Trends exist outside cycles, although they are influenced by them.
2. Trends are easier to forecast and as a result shocks that change trends, such as war or
market dislocations, have major effects.
3. Trend growth doesn’t change much over time, however during industrialization &
development countries often move through progressively lower trend growth rates.
4. Consumer Impacts: Consumers largest source of growth
i. Consumption is correlated with wealth, but is quite stable (even sometimes
countercyclical) through cycles.
a. Consumers usually moderate savings levels to maintain spending levels.
ii. Permanent Income Hypothesis (M. Friedman) – consumers’ spending determined
by long-run income expectations.
a. Temporary/one-time changes in wealth little effect on spending patterns.
5. Sources of growth
i. Growth in labor inputs (more workers)
a. Both population and labor participation (think women entering workforce)
b. Can be affected by policy. Low population growth can be offset with
policies to encourage participation (reduced age benefits, more child care).
 ii. Growth in labor productivity
a. Growth can come from investment in capital inputs or;
1) Rapidly growing countries are often heavily investing in capital
inputs. Investment can increase your trend.
2) One reason why equity returns can be less than GDP  equity is
return on invested capital, growing the denominator lowers the
return.
b. Growth in total factor productivity (TFP), technological progress increasing
efficiency of capital inputs.
1) Technological shocks or changes in government policy.
2) Often identified in data the “residual” – unexplained growth.
6. Government Structural Policies affect the limits of growth and private sector incentives.
i. Sound fiscal policy is important. Budget deficits are useful cycle tools, but long run
deficits must be financed. This financing:
a. Takes resources away from the more efficient private sector
b. Is sometimes financed by printing money  inflation.
c. Often results in a current account deficit  borrowing from abroad.
1) If this borrowing gets too high, borrowing must be scaled back,
currency devalued (often in destabilizing).
ii. Minimal public sector intrusion: Marketplace provides the best incentives, so limit
distortion.
a. Some needed to supply public goods and help balance negative externalities
b. Most damaging are labor regs  lead to structural unemployment.
iii. The government should encourage private sector competition. Competition drives
efficiency which drives productivity.
a. Reducing barriers to trade and investment help.
b. Can reduce stock returns however, prevents high returns on capital.
iv. Supporting infrastructure and human capital development is important.
v. Sound tax policies. Government provides important basic services and redistributes
wealth, but taxes limit growth. Sound policy is simple, transparent, stable. Low
marginal rates. Broad tax base.
7. Exogenous shocks can alter the stable course of trends and are rarely built into prices or
anticipated.
i. Most trend shifts come from changes to government policy.
ii. Technological changes are more than short term shocks  think communications
development creating compounding increases in long term TFP.
iii. Oil shocks can move inflation up sharply, however it also causes employment
contraction and output gaps  slow the economy and bring inflation back to trend
iv. Banks are particularly vulnerable to asset prices, esp. property. To keep the
payment system running loosen monetary policy.
a. Difficult to do in low inflation/deflation environments, hence banking crises
are that much worse when the start in one.
8. International interactions are more important for small countries.
i. Business cycles can cross borders by affecting foreign demand for exports or
reducing ability for foreigners to invest in local market.
ii. Exchange rate policies can transmit monetary policy internationally (pegs).
a. Pegs provide domestic businesses exchange stability and control inflation
b. Interest rates between the peg and the pegger will vary depending on the
confidence in the stability of the peg (more confidence. Less spread on top
of the peg’s rate)
iii. If country A’s exchange rate is considerable undervalued to B and expected to rise,
A’s bond yields will be lower in relation to B and vice versa.
iv. Theoretically real bond yields should be relatively equal, over/undervalued
exchange rates create distortions. Real bond yields do move together though due
to their link to the world supply/demand of capital.
9. Emerging markets exhibit key differences from developed markets
i. Catching up  requires large investments  less domestic savings  requires and
draws in foreign capital to finance  managing this deficit leads to crisis.
ii. Without a large stable middle class often volatile political and social environments.
iii. Often require major structural reform to unlock potential, which can be difficult (ii)
iv. Economies are relatively small and concentrated in particular commodities/goods
v. Evaluating country risk:
a. Bond investors concentrate on ability to pay
 b. Equity investors focus on growth potential and vulnerability to shocks.
c. How sound is fiscal & monetary policies? Ratio of deficit / GDP
d. Growth prospects for the economy? Driven by gov. structural reforms
e. Competitive currency? External accounts under control? Volatile exchange
rates negatively influence business confidence/investment.
1) Overvalued currency usually means too much foreign borrowing
2) Measure with current account deficit – too much makes a country
uncompetitive, often leads to devaluation & recession.
i. Better if the CA deficit is financed by FDI rather than debt.
f. External debt under control? Foreign debt/GDP
g. Is liquidity plentiful? Foreign exchange reserves to trade flows & short
term debt. Ability to keep buying imports. Too much ST debt means it can’t
get LT debt, eventually it may not get ST debt either than crisis.
h. How supportive is the political situation of needed policies? Most
important when other indicators look shaky. Reforms can be painful to
constituencies and/or vested interest, is the political establishment strong
enough?
VI. Economic Forecasting
1. Econometric models – formal, mathematical approach
i. Models relationships between variables.
ii. Built using economic theory then optimized (such as least squares regression) using
historical data to estimate factor sensitivities.
iii. Models have different structures that reflect modeler’s views on what variables to
include and how they interrelate (such as lags).
iv. Good for simulating the effects of changes in exogenous variables.
v. Limitations include: data sources/availability, variables measured w/ error, regime
changes diverging past relationships in the present.
vi. Merit is forces some degree of consistency and challenges modeler to reassess prior
views based on model conclusions.
vii. Traditionally better at forecasting upturns than downturns.
2. Using economic indicators – analyzing variables that precede or lag turns in the economy.
i. Leading indicators vary with the cycle but fairly consistently ahead of it.
 a. Simplest method, watch a few variables to predict
b. Diffusion index combine indicators to give a picture (7/10 up  growing).
ii. Coincident indices (same time), lagging indices (behind).
3. Checklist approach – subjective integration of the answers to set of questions
i. Straightforward but time consuming look at broadest range of data.
ii. Use the answers to forecast with either objective models or judgment.
iii. Main weakness is subjective nature

Advantages Disadvantages
Econometrics
 Robust models w/ many factors  Complex, time-consuming to create
 Once built easily repopulate w/ new data  Inputs & relationships uncertain & variable
 Provides quant estimates of effects of ∆s  Must carefully analyze output
in exogenous variables  Poorly forecasts recessions
Leading Indicators
 Intuitive & simple & customizable  Relationships between inputs not static 
 Available from 3rd parties historically has not consistently worked.
 Robust literature of existing usage  Can provide false signals
Checklist
 Limited complexity  Subjective, time consuming
 Flexible – easy to change  Complexity limited due to manual nature

VII. Using Economic Forecasts in CME

1. Cash & Equivalents
i. Limited due to very nature, but length of maturity of paper in the portfolio dictated
by views on interest rate movements.
ii. Short paper rarely deviates from central bank rates  cash managers are trying to
forecast not only economy but how central bank will react.
2. Nominal default-free bonds (essentially developed economy government bonds)
i. All about yield curve expectations. Break it down into 2 components:
a. Real bond yield – GDP growth and supply/demand for capital. Historically
US 1.6%, ex ante (poor inflation forecasting) expected to be 2-4%
1) Strong growth often raises yields (more demand for capital,
inflation)
2) Short rates mixed  often rises raise long term yields, however if
the rise is expected to slow growth long yields could fall.
b. Inflation forecast – inflation drives yields up (prices down).
 1) Faith in central bank’s ability to achieve inflation target dictates
effect of inflation expectations.
2) Long term holders must be very concerned here.
3. Defaultable debt – add credit risk
i. Individual securities driven by their issuer’s prospects, but market primarily driven
by cycle & short rates.
4. Emerging Market Bonds – Developing countries debt
i. Usually borrowing in foreign currency  can’t inflate out so higher default risk
ii. Country risk assessments  usually driven by predicting policy movements, can the
government enact needed reforms to stabilize economy?
5. Inflation-indexed bonds – government issued, guaranteed to return inflation index
i. Can see inflation expectations through spread over equiv. non-indexed gov bonds.
ii. Theoretically should just be real risk free rate, but actually distorted by 3 factors:
a. Growth: High growth  high short rates  yield rises
b. Inflation: high expectations raises the “value” of the hedge  yield falls
c. Supply/demand: Factors effecting institutional demand, such as tax.
6. Common Shares
i. Look at how economic factors affect (1) earnings and (2) rates, bonds, & liquidity
ii. Aggregate corporate earnings long run determined by trend growth with short run
variation.
iii. Recessions drive down earnings except in stables. Large fixed costs/pronounced
sales cycle industries are particularly cyclical
iv. Upturns lead to quick profits  increased volume + under capacity = no new costs
a. Existing high unemployment holds down wages, further raising earnings.
b. Companies are usually leaner & more efficient – fat trimmed
v. P/E ratios tend to be high and rising when earnings are expected to rise.
a. P/Es of cyclical companies are often above historical means during
recessions due to the expected sharp increase during recovery.
b. P/Es vary over long stretches. Slow trend growth leads to low P/Es.
1) Inflation depresses P/E because it distorts the meaning of earnings.
Important to adjust for inflation rates to compare P/Es over time.
 vi. Emerging market risk premium correlated with developed economy cycles  macro
effects flow through trade (purchase of inputs) and finance (capital flows)
7. Real Estate
i. Consumption, real interest rates, yield curve, & unexpected inflation drive return
ii. Rates influence construction financing & mortgage costs
8. Currencies – exchange rate reflects balance of buyers & sellers
i. From a trade perspective want an exchange rate that keeps the current account
balance 0.
ii. Trade has diminishing import  investment growing in importance.
iii. Strong domestic growth/reduced barriers lead to demand for that currency.
a. Flows into financial assets (stocks, bonds, cash) very volatile. FDI stable.
iv. Foreign flows influenced by growth and rates. Rising rates typically strengthen
currency.
a. Sometimes this reverses if rates are seen as slowing the economy.
v. If a currency departs from its trade 0 value, capital flows may become too large to
finance. Major currencies can experience prolonged over/under valuations around
along run equilibrium.
a. Pegs and capital controls help control this and bring stability at the cost of
periodic large, sudden movements.
9. Forecasting Exchange Rates: 4 broad approaches
i. Purchasing Power Parity – exchange rate movements offset inflation differences
ex CAD price level up 10.41%, Euro up 15.93%. Inflation differential:
-5.52%. CAD appreciate vs Euro by same.  If starts $1.3843 CAD/Euro will
become (1-5.52%) X 1.3843 = 1.3079 CAD / Euro.

a. Useful in the long run, >5 years. Less so in medium and esp. short term.
b. Governments take it seriously to avoid sudden exchange rate movements.
c. Huge rises in capital flows recently  currencies depart from PPP
d. Other factors can cause dislocation, such as large current account deficits.
ii. Relative Economic Strength focuses in investment rather than trade flows
a. Strong growth creates attractive investment opportunities, leading to
currency demand.
 b. High interest rates create similar effect  extra yield compensates investors
for overvalued currency risk. More of a short term effect.
c. Combines well with PPP to paint the full picture.
iii. Capital Flows approach focuses on expected long term capital flows, e.g. FDI
a. Can reverse the effect of high interest rates because cuts in rates expected
to boost growth & stock market, making long term investment attractive.
1) Reduces central bank effectiveness (lowering rates pushes up the
exchange rate instead of down, reducing competitiveness  not as
stimulatory policy as desired)
iv. Savings – Investment Imbalances  currency movements caused by domestic
savings-investment gaps.
a. Idea is if economy starts growing and demanding investments > domestic
savings, foreign capital must enter to fill the gap.
b. Increases demand for currency and pushes exchange rate above equilibrium
c. Effect can cause long term dislocation above and wide current account
deficit, then when it reverses long term dislocation below to reduce deficit
10. Government Intervention in Currency Markets
i. Governments periodically try to control exchange rates.
ii. Economists skeptical for 3 reasons:
a. Forex markets are huge in comparison to central bank foreign reserves.
b. Government authorities are just another player in the market
c. Absence capital controls, limited historical success.