Capital Market Expectations

Sara is a portfolio manager. Her job is to seek out ways to achieve the best trade-offs between risk and return. When she develops an investment strategy for a customer, it includes structuring the right mix of investments that can balance desired returns and their associated risks. Sara's __capital market expectations__ (CME) are her outlooks on risk and return for each of the asset classes within the portfolio she is creating for TriStar Development. She needs to consider asset-class expected returns, their standard deviation, and correlations among pairs of asset classes. She knows that asset classes are cash reserves, bonds, and equities. In setting capital market expectations, what do you suppose Sara should do first?

No. This is the strategic asset allocation, which cannot be performed until the capital markets expectations are established for the intended portfolio.

Yes. Sara should work from the top down, starting with TriStar's portfolio goals. She should identify the time horizon for investments and decide how best to computer model the market performance for each of the asset classes that are to be in the portfolio.

No. This cannot be done because a time horizon hasn't been set.

Sara feels that a percentage of the portfolio will need to contain money market securities which will cover the cash reserves asset class of the portfolio. What makes a money market security suitable for this?

No. Money markets contain bank certificates of deposit (CD), commercial paper, and treasury bills, which all provide liquidity. Their returns are extremely low.

Yes. Treasury bills, commercial paper, and certificates of deposit (bank CDs) are all liquid assets that earn almost zero return on investment.

What do you suppose would be included for the equity class expected return?

No. The risk-free rate is the rate assigned to the asset class with the lowest expected return. In this case, that is the cash reserves class.

Yes. For the equity class, as well as the bond class, the expected rate of return is calculated by adding the risk-free rate of return to the risk premium. The risk premium includes risk for inflation, default, liquidity, and maturity. Sara is able to obtain information from bond yield curves as well as use the Capital Asset Pricing Model (CAPM). Once she has profiled risk and expected returns, she is able to go back to TriStar to begin the strategic selection of assets.

No. The expected rate of return would never dip below the risk-free rate.

To summarize: [[summary]]

Sara can determine the parameters for the cash reserves asset class because she is able to obtain historical macroeconomic data and study economic outlooks for government securities, inflation rates, and money supply. The expected return can be estimated as the US T-bill rate, and this is also assumed to be the risk-free rate (no inflation assumed). Once Sara can model the cash reserves asset class, she may move on to the other classes, which will contain all of the risk. She will have to be aware of correlation—how the two asset classes have moved in relation to each other. Historical information about bond market and stock market performance is useful, but she must also consider interest-rate movements as she looks forward. Fortunately, standard deviation and correlation information can be researched and placed into her computer model.

Review historical trends for bonds and equity markets

Establish a final set of risk and return expectations

Select components for asset classes

Money markets usually provide a good rate of return

Money market securities contain liquid assets

The risk-free rate less a risk premium

The risk-free rate plus a risk premium

The risk-free rate

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