Economics

- Rest Mon, Stim Fisc  Flat

- Stim Mon, Rest Fisc  Steep
o Cash
 It is a floating rate instrument with zero duration
 It earns the real rate of interest when inflation is within expectation
 A greater than expected inflation  Cash yields Less
 A less than expected inflation  Cash yields More
 Inverse Relationship between differential of expected inflation and cash yield
o Bonds (Nominal Fixed-Rate Bonds)
 Bond prices and interest rates have an inverse relationship
 Short term bond yields are more volatile than long term yields when inflation is within expectations
 Higher/lower than expected inflation, makes the long-term bonds yields more volatile
 Long term different from expected  Volatility Higher

o Net Exports = Net Private Saving + Government Surplus

o Term Premium and its relation to Recession Hedge
 If inflation is a result of aggregate demand
 Leads to low term premiums
 Nominal bonds returns and growth are negatively correlated
 Demand Negative Term Premium Low
 If inflation is caused by aggregate supply
 Leads to higher term premium
 Nominal bond returns and growth are positively correlated
 Supply Positive Term Premium High

o Credit Premium is positively related to the following:

 Slope of the Yield Curve
 Volatility of the Equity Markets

o Real Estate
 Expected Return = Cap Rate + NOI Growth Rate
 For Finite Periods  Expected Return = Cap Rate + Change in Cap Rate + NOI Growth Rate
 Cap Rate is used as the discount rate for valuing real estate property over the long term
 Cap rates are positively linked to long-term interest rates
 They do rise in an expanding economy and fall in a recessionary economy

o Currency
 Expected change in exchange rate should be in line with expected inflation rate differentials
 Under the UIRP (Uncovered Interest Rate Parity), all premiums are useless

o In Volatility Estimation
 ARCH Models: Used to address volatility clustering
o We can use Black-Litterman Framework to combine all models
During the slowdown or business cycle or the late upswing  Yield Curve is Flat or Inverted and is
expected to steepen in the near term
 o High-frequency data are more sensitive to asynchronism
o High-frequency data produce more precise variances and co-variances (and less precise means)

Expected equity risk premium (Expected Risk Premium) = Expected equity return − Current 10-year government
bond yield
- Taylor’s Rule (Forecast Minus Trend)

- FX  NO Interim Interest Payments

Derivatives