Investment Ideas - Capital Market Assumptions (CMA) Methodology - 5 July 2012 - (Credit Suisse) PDF

New York, 5 July 2012
Global Research

Important disclosures are found in the Disclosure appendix
Executive summary
The asset allocation process involves 78 assets (in effectively
seven asset classes) for which Global Research provides five-
year total return forecasts and volatility and correlation
estimates. Total return forecasts are derived directly from the
Global Research coverage universe or models constructed to
provide quantitative forecasting guidelines which are balanced
with qualitative judgments.
This paper sets out the framework for calculating forecast
returns, volatilities and correlations for equities, alternative
investments (hedge funds, private equity, commodities and
real estate), sovereign and corporate bonds, and money
markets, which then feed into the optimization process that
produces asset allocation recommendations. Wherever
possible, we adopt common assumptions and methodologies
across the asset classes to achieve some consistency in return
forecasts, in addition to using a single methodology for
forecasting volatility.
All results are systematically subjected to a qualitative
consistency check, which involves a cross asset-class
comparison of risk-adjusted returns, a comparison with
historical data and a comparison of long-term macro trends
with forecasts.
Where inconsistencies or inconclusive results are
identified, we err towards the more conservative estimate. All
forecasts and models are clearly documented.

Research Flash
Investment Ideas
Capital market assumptions (CMA) methodology
Private Banking

Highlights
Where possible, we follow common and (if
feasible) related approaches to forecasting
returns across seven asset classes (and a
total of 78 assets).
Key variables used in our models are inter-
related at a fundamental level and in many
cases rest on our underlying macro
assumptions.
A common approach to forecasting
volatility is used across most asset classes.

Research Flash 2
Introduction
A key part of the Capital Market Assumptions project is
forecasting total returns and volatilities for 78 assets
(effectively from seven asset classes money markets,
equities, fixed income, private equity, hedge funds,
commodities and real estate).
Where possible we follow similar if not related approaches
to forecasting returns for the various asset classes. For
instance, many of the underlying macro assumptions that are
used as factors in multi-linear regression models come from a
common source our macroeconomic teams forecasts. In
addition, the underlying rationale behind our forecasting
models is similar. For instance, specific supply/demand drivers
as well as the impact of financing costs are key factors in our
commodities and real estate forecasts. In the longer run, most
of the key variables used in our models should be closely
related, as bond yields, GDP and dividend growth tend to
converge over time. More specifically, for most asset classes
we use clearly specified multi-linear regression models to
forecast returns, while relying on the traditional Dividend
Discount Model in the case of equities. The object of this
exercise is to arrive at five-year return and volatility forecasts
for each of the assets, which are then used as inputs for the
final optimization process. To an extent, forecasting returns for
a five-year period is less error-prone than for a much shorter
period and also lends itself to a greater reliance on longer-term
fundamentals as drivers of future performance. It also means
that incorporating a mean-reverting element into the return
forecasts is far less controversial than perhaps it would be over
a shorter time horizon.
It is also worth mentioning that all our models are
supported by cross-checking procedures that aim to rationalize
the initial forecast outputs. Our commodities team, for
example, uses a scorecard approach as a consistency check
on forecasts. To a certain extent, return forecasts should have
relatively little impact on forecasts of volatility and covariance.
Risk, or volatility, is more a measure of the uncertainty of the
return, rather than the forecast of the return. In the shorter
term, underlying risk and covariance should be more stable
than expected returns.
With regard to volatility forecasts, we compute historical
volatilities, correcting for auto-correlation where necessary as
suggested in econometric literature. Historical volatilities
corrected for autocorrelation are taken as the best proxy for
five-year average volatility forecasts for most assets as
volatilities tend to be mean-reverting, although with a different
degree of auto-correlation from one asset class to the other.
For emerging market equities, qualitative evidence suggests
the possible existence of a structural break by which historical
volatilities could overestimate future volatilities. We also find
statistical indications in this direction and hence correct
historical volatilities to account for the possible structural
break.
The correlation matrix is estimated using all the available
history of time series, using the Stambaugh algorithm. The
Ledoit-Wolf shrinkage methodology is applied to reduce
estimation error in the calculations of the correlations, while
taking into account the different correlation patterns between
major asset groups such as bonds and equities. We combine a
prior matrix with the Stambaugh matrix by calculating a
shrinkage factor. The result is a well-behaved correlation
matrix with reduced estimation error. The variance-covariance
matrix is in turn obtained by multiplying the correlation matrix
with estimated variances.

Research Flash 3
Long-term macroeconomic forecasts
Long-term economic forecasts primarily remain based on
OECD estimates of potential growth. These are derived
from a production function linking input and output
variables of an economy. In view of some methodological
drawbacks of the OECD approach, we have also drawn
on another purely supply-side methodology where reliable
sources were available.
The short end of long-term forecasts reflects
macroeconomic forecasts for the next 18 months based
on a demand-side approach.

Both in the short-, medium- and long-term, asset returns are
closely related to the growth of the underlying economy which
generates the investment returns. In the shorter term, cyclical
policy actions, especially monetary policy shifts, have a
considerable impact on economic performance while, in the
long term, macro policy is generally regarded as being
"neutral."
In the longer term, a countrys GDP should, on average,
grow at its potential growth rate. In this steady state
environment, unemployment rates are stable and inflation
neither accelerates nor decelerates. An increase in production
above this trend would result in an increase in inflation; a drop
below this level would, ceteris paribus, reduce inflation or even
cause deflation.
The potential growth of an economy depends on the
development of the capital stock, the labor force and
technological progress. Long-term developments in the labor
force are mainly determined by demographic and socio-
economic trends such as birth rates and migration flows.
Technological progress, however, is a more complex
phenomenon which depends on many factors such as
educational systems, openness and incentives for learning etc.
Many different ways to measure potential output have
been proposed, ranging from simple statistical measures (e.g.
a Hodrick-Prescott filter to estimate trends) to more structural
economic models. The results of simple statistical measures
and univariate techniques depend to some extent on factors
such as sample length, estimation parameters and out-of-
sample restrictions. In its growth accounting exercise, the
OECD has opted for a production function approach which
breaks down growth into three components: capital stock,
labor supply and factor productivity. This breakdown of growth
allows the identification of each factor over time.
In the OECD model, the production technology for the total
economy is assumed to be a constant return to scale Cobb-
Douglas production function with capital stock, labor supply
and factor productivity as input factors. Factor productivity is
included in the Cobb-Douglas function as labor efficiency, i.e.
factor productivity is multiplied directly by the labor supply, but
not by the capital stock (Harrod neutrality). The power
parameters of the Cobb-Douglas function are calibrated by
averaging the respective factor-earning share over the sample
period. The production function can be expressed by the
following formula:

o o
=
1
* ) * ) 1 ( * * * ( C H NAIRU PR Pop LE Y

where LE stands for labor efficiency, Pop for population, PR
for labor force participation rate, NAIRU for non-accelerating
inflation rate of unemployment, H for hours worked and C for
capital stock.

Figure 1
Real GDP in the G3

-10
-8
-6
-4
-2
0
2
4
6
02 03 04 05 06 07 08 09 10 11
Eurozo ne USA Japan
in %
Source: Thomson Reuters DataStream, the BLOOMBERG PROFESSIONAL service,
Credit Suisse
Figure 2
Stylized business cycle and potential growth
Potential
growth
Economic cycle
Source: Credit Suisse

Research Flash 4
In contrast to previous estimates, the OECD has recently
been using a total economy approach for measuring potential.
Previously, the focus was on the business sector, but the
prevalent use of chain-linking in national accounts makes it
increasingly difficult to calculate business sector figures. This
approach also ensures better comparability with potential
growth estimates from other sources, which mainly use a total
economy approach as well.
In the OECD models, the factor labor force is derived by
the product of the non-accelerating inflation rate of
unemployment (NAIRU), the working age population, the
participation rate and the annual amount of hours worked per
employee. The NAIRU is estimated by a reduced-form Phillips
curve approach, which combines a structural equation relating
inflation and unemployment to statistical techniques to
constrain its path. While this method has the advantage of
providing more timely and robust estimates of the NAIRU than
purely structural models, it gives little insight into its
determinants and thus makes forecasting more difficult.
The unobserved factor productivity is expressed by the de-
trended residuals of the Cobb-Douglas function after solving
the function for factor productivity. This adds an element of
arbitrariness to the estimates, since labor efficiency is not
modeled and its future behavior is thus hard to predict.
The capital stock is obtained by the sum of yesterdays
capital stock after depreciation and todays investment activity.
This capital service approach combines both a scrapping rate
and an efficiency profile for the capital stock. It places more
weight on assets that depreciate more quickly, since their
marginal product should be higher to justify their cost.
Information and computing technology equipment, whose
productive value diminishes very rapidly, is therefore better
captured than in national account measures of the capital
stock. Since this measure is calculated directly, it is more
comparable than national account figures, where different
calculation methods are used. Capital services measures of
the capital stock grow more rapidly than traditional estimates
of the capital stock, thereby reducing the importance of labor
efficiency and thus making the whole estimate more tractable.
Using the original values of these series can result in
substantial volatility of potential growth estimates, especially due
to variation in the NAIRU, the capital stock and working-age
population. Therefore all series are de-trended by an HP-filter.
For the potential growth projections, the NAIRU and the trends
of the other factors are extended exogenously using additional
assumptions on a judgmental basis. For example, the trend
labor participation is calibrated using a method which takes
account of underlying demographic changes and cohort
effects.
Notwithstanding these efforts by the OECD to smooth the
estimates of potential growth, we have found that the impact
of the recent state of the labor market (and the associated
Philips curve, or NAIRU) remains very strong. Given that we
are attempting to estimate a growth trend that begins fairly far
in the future, we have decided to reduce the impact of the
current labor market situation on the growth estimate. In other
words, we include growth models in which wage flexibility
clears the labor market, so that the impact of demography and
productivity is strengthened. We have begun to make these
adjustments to the estimates where reliable sources are
available.
For the United States, long-term growth estimates which
are unconstrained by the NAIRU are provided by Robert
Gordon of Northwestern University ("Revisiting U.S.
Productivity Growth over the Past Century with a View of the
Future", NBER Working Paper No. 15834, March 2010). In
the UK, we have drawn on the Office for Budget Responsibility
(November 2011). Finally, as regards Switzerland, the recent
increase in immigration and resulting growth of the labor force
does not yet seem reflected in the OECD estimates. The
resulting estimates for potential growth are thus as follows:
United States (2.2%), Euro area (1.3%), UK (1.9%), Japan
(0.8%) and Switzerland (1.6%). Going forward, we will seek
to refine our trend growth estimates using the dual
methodology (NAIRU-constrained and unconstrained)
described above.
The potential growth estimates serve as the anchor for our
long-term forecasts. We assume that, over a period of three
years, the economies reach their potential growth, and then
grow at that pace to the end of the five-year forecast horizon.
We also develop side-scenarios (weak and strong) for the
economies. Here, trend growth is either one standard
deviation higher or lower relative to the past 10 years.
To describe the adjustment path to potential GDP, we link
our long-term growth assumptions with our short-to-medium-
term GDP projections.
There are three ways to measure GDP: via the production
side, via the expenditure side and via the income side. The
production side sums up the contributions of the various
sectors of the economy, while the demand side commonly
consists of private and government consumption, investment
and net exports. The income side shows the distribution of
national income between profits and wages.
For our purpose, we focus on the expenditure side, since
data is more readily available and the factors that influence the
components are more easily identified and most importantly,
interpreted. The following formula describes the demand side
of the economy:

Y = C + I + G + NX

Y stands for output, C for private consumption, G for
government consumption, I for investment and NX for net
exports. The relevance of these components varies from country
to country. While private consumption accounts for 70% of
GDP in the USA, it is only slightly above 50% in Germany.
Assuming a permanent income hypothesis, private consumption
mainly depends on disposable income, which predominantly
consists of labor income and to some extent on private wealth,
which refers to both housing wealth and portfolio investments.
For all countries concerned, the influence of labor income is by
far more important than wealth variables. Next to the
income/wealth channel, there is also a credit channel
determining private consumption. The willingness and ability of
banks to grant credit to households and the ability of households
to pay the price of it, e.g. interest, is therefore crucial.
Investment depends on the level of capacity utilization,
costs of funds and expectations about future demand.

Research Flash 5
Government expenditure mainly consists of the wages of
public employees and of public investment, while transfers are
merely redistribution and do not qualify as consumption. Net
exports are exports less imports and are mainly determined in
the short term by domestic and foreign demand.
Our short- to medium-term (2-year) forecasts are based
on a qualitative assessment of these various demand
components making use of various "leading" indicators where
they appear to have a sufficient lead. Amongst others we pay
close attention to trends in market, or consensus,
assessments of the cyclical outlook.
Finally, we assume that central bank credibility will keep
inflation expectations in check and that the central banks
inflation target will be reached in the longer run. Since we also
assume that economies are in steady state in the longer run,
this implies that inflation converges to the central banks target
in our longer-term projections. In the short term, however,
there can be substantial deviations of inflation around this
target. If the economy is running above potential, inflation
tends to rise, while the opposite is the case if resources are
underutilized. Volatile food and energy prices are also key
determinants of inflation variation on the shorter horizon. Given
the highly activist monetary policy of the past years which has
led to unprecedented expansions of central banks' balance
sheets it is clear that uncertainty over longer-term inflation
trajectories is also quite considerable.

Research Flash 6
Interest rate forecasts
Beyond cyclical considerations, we use potential GDP
growth and medium-term inflation in steady state to derive
short-term interest rate forecasts over the medium term.
We employ a fair value model based on long-term
macroeconomic factors, complemented by underlying
macroeconomic growth, inflation and interest rate policy
scenarios as an anchor point of our long-term interest rate
forecasts.

We use 3-month Libor rates as a proxy for money market
interest rates. In normal market conditions, they display a small
spread to central bank policy rates. In the medium term, we
assume that central bank policy rates converge to a neutral
level, i.e. a level that is neither expansionary nor restrictive and
is consistent with trend inflation. Empirical research shows that
neutral interest rates roughly correspond to nominal trend GDP
growth in industrialized countries. Nominal trend GDP growth
can in turn be decomposed into two factors: real potential
GDP growth and trend inflation. Our methodology for real
potential GDP growth was described in the previous section.
For inflation, we assume that central bank policy is credible
and successful in the medium term, i.e. inflation converges
towards the central bank target. Central banks deliberately
deviate from a neutral level of interest rates in order to
stimulate or cool down the economy. This is reflected in our
near-term projections, which take account of the business
cycle and the corresponding response by central banks.
An approach that helps us forecast central banks' future
monetary policy stance over the more cyclical horizon is the
so-called Taylor rule. This rule stipulates that the central bank
should base the level of its policy rate on the deviation of
output from potential output and on the deviation of inflation
from the central bank's target. Instead of the output gap, one
can also use other approaches like the deviation of
unemployment from a level, which is consistent with stable
wage growth. Figure 3 shows such a Taylor rule for the USA.
Long-term interest rates are forecast within a multivariate
econometric framework (vector autoregression) that is
calibrated on 2-year yields along with yield curve spreads
between 2-year yields and longer maturity segments of the
yield curve (2s3s, 3s5s, 5s7s and 7s10s spread). The model
follows the idea of a curve premium model inspired by
Cochrane and Piazessi (2005) and Piazzesi and Ang (2003).
1

This setup is enhanced with macroeconomic data presented
on the previous page (i.e. the forecast for the output gap and
trend inflation) in order to derive a steady state Taylor-rule-
based money market rate that is related to the forecast on
money market rates (3-month interbank rates).

1
See Chochrane and Piazessi (2005), Bond Risk Premia, American Economic
Review, Volume 95, Issue 1, pp. 138-160 and Piazzesi and Ang (2003), A No-
arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic
and Latent Variables, Journal of Monetary Economics, Volume 50, Issue 4, pp.
745-787.
The gap between expected Taylor rule steady state rates
and expected money market rates is also used as an
exogenous variable in order to explain the term premium. The
latest forecast for the US Treasury yield curve, based on the
core scenario assumption for GDP growth and inflation, is
shown in Figure 4.
The exception to the described procedure is the yield
forecast for Singapore government interest rates. Given that
Singapore has a pegged exchange rate its monetary reaction
function cannot be summarized within a Taylor-rule framework.
Our interest forecast for Singapore government bond yields
are therefore modeled along with our economist's expectation
on SGD Libor rates and the trajectory for USD Treasury yields
using a simple OLS framework.

Figure 3
Example: Taylor rule for the USA
- 2
- 1
0
1
2
3
4
5
6
7
1992 1996 2000 2004 2008 2012
Fed f unds r ate
Taylor r ule estimat e (unemployment gap and c ore PCE inflation)
%
Figure 4
Example: Estimated yield curve segments for US-Treasuries
over coming 5Y horizon along with central bank policy rates.
-0.50
-
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16
Y
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)
US 3M Libor rate - median fc. US 2Y gov.yield - median fc.
US 5Y gov.yield - median fc. US 7Y gov.yield - median fc.
US 10Y gov.yield - median fc.

Research Flash 7
Fixed income indices
All fixed income indices are modeled according to
individual, co-related bond price characteristics (spread
vs. benchmark, expected coupon, expected average
duration and pull-to-maturity), for which separate
forecasts are produced if the time series are available.

Fixed income total return (TR) indices reflect accruing
interest and price returns. To capture better the composition of
bond total returns we have developed total return
component-based models. Component-based in this context
refers to the fact that we forecast each total return component
separately. This concept becomes clearer if we recall the
calculation of bond total returns (see equation below).

( )
t
y P
C y
t
P
C
y MD r
avgL
red
red
red index
A
+

+ A + A ~
1
100
(1)

change in price accrued coupon pull to parity

The calculation of the total return is centered on the standard
total return formula for conventional bonds (non-callable, non-
sinkable, no step-up. etc.) without accounting for convexity. To
solve the above equation we need the following variables: MD:
modified duration, avgL: average life of bond in the index, C:
average coupon, y: index redemption yield, P: hypothetical
bond price of a regular bond assuming previous index specific
variables.
2
The return of a bond investment is approximated by
the change in bond yields multiplied by the modified duration
of the bond, the accrued interest rate and the pull to parity
(every conventional bond is redeemed at 100). We apply this
bond pricing formula on an index level.
Knowing the input variables for the above total return
formula enables us to calculate the appropriate index return
and hence also the overall development of the bond index. To
account for unobservable index characteristics, we run a
conventional OLS regression of the total return, defining
elements against the index we are looking to explain.

t
t
avgL
red
y P
C
red
y
t
P
C
red
y MD
index
r c | | | +
|
|
|
|
|
.
|
\
|
A
|
.
|
\
|
+

+
|
|
.
|
\
|
A + |
.
|
\
|
A =
3
1
100
2 1
(2)
This is necessary since some of the analyzed bond indices
(especially the municipality indices) have non-conventional
bond structures (primarily callable bonds) that cannot directly
be approximated by equation (1).
Along with the above regression, we estimate
simultaneously a set of equations to forecast the redemption
yield, the average index coupon, the average life and the
modified duration of the index as a function of the endogenous

2
See K. Nyholm (2008), Strategic asset allocation in fixed-income markets, Wiley
Finance, p. 67 to derive the entire formula.
and exogenous variables, i.e. we forecast all total return
relevant components jointly.

( ) yield benchmark factors, macro f Cspread =
( ) yield benchmark spread, credit f y
red
=
( ) duration modified yield, redemption f C =
( ) process hlenbeck Ornstein U reverting mean f avgL =
( ) duration modified yield - par analytical f MD =

Special attention is attributed to the redemption yield and
credit spread equations. The benchmark yield is assumed to
be an exogenous variable and estimated separately (see
previous section on interest rate forecasts). The credit spread,
however, is forecast within this system of equation by
incorporating relevant macro variables defined by every analyst
individually). The used macro and benchmark yield data will
vary across the economic scenarios. Both components result
in the overall redemption yield forecast, which itself becomes
an endogenous variable for estimating the future profile for the
nominal coupon, the average life and duration of the index.
This process results in forecasts for five different total return
components that are re-assembled via the estimated equation
(2), to form a total return index forecast. The advantages of
this integrated component forecast approach become clear if a
specific example from the 20112012 sovereign crisis period
in Europe is analyzed.
Figures 5 to 10 show the individual component forecasts
along with the resulting total return estimate for the Barclays
Euro Agg 10+ Y government produced in H2 2011.
The major component (the spread to German benchmark
yield) is expected to revert to some degree, depending on the
economic outlook. Should the European economy remain
under pressure, the spread will likely stay elevated over the
coming years. A higher spread, however, does not mean that
the overall redemption yield of the index increases. As shown
in Figure 6, a weak economic recovery will be accompanied by
much lower long-term redemption yields (due to the falling
benchmark yield as shown in Figure 7). This shows how we
cannot separate the credit component in each index from the
benchmark (rates) element.
Together with the forecast of the average index coupon
and the assumption that the average index life is unaffected by
macroeconomic data and yield levels (i.e. we assume average
life to simply mean reverting or unchanged at the current
level), we can calculate the hypothetical modified duration of
the index.

Research Flash 8

Figure 5

Figure 6
Credit spread forecast for BarCap Euro Agg 10+Y bond index

Redemption yield forecast for BarCap Euro Agg 10+Y bond
index
-0.50
0.00
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3.00
Dec-99 Dec-03 Dec-07 Dec-11 Dec-15
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%
EMU Govt, Long Term - benchm. spread
EMU Govt, Long Term - benchm. spread (fcm.)
EMU Govt, Long Term - benchm. spread (fcs.)
EMU Govt, Long Term - benchm. spread (fcw.)

2.00
2.50
3.00
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%
EMU Govt, Long Term - avg. red. yield
EMU Govt, Long Term - avg. red. yield (fcm.)
EMU Govt, Long Term - avg. red. yield (fcs.)
EMU Govt, Long Term - avg. red. yield (fcw.)

Figure 7

Figure 8
Benchmark yield forecast (Germany) for BarCap Euro Agg
10+Y bond index

Average coupon forecast for BarCap Euro Agg 10+Y bond
index
0.00
1.00
2.00
3.00
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5.00
6.00
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EMU Govt, Long Term - benchm. yield (Germany)
EMU Govt, Long Term - benchm. yield (fcm.)
EMU Govt, Long Term - benchm. yield (fcs.)
EMU Govt, Long Term - benchm. yield (fcw.)

4.00
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EMU Govt, Long Term - avg. coupon
EMU Govt, Long Term - avg. coupon (fcm.)
EMU Govt, Long Term - avg. coupon (fcs.)
EMU Govt, Long Term - avg. coupon (fcw.)

Figure 9

Figure 10
Modified duration forecast BarCap Euro Agg 10+Y bond index

Total return forecast BarCap Euro Agg 10+Y bond index
10.00
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EMU Govt, Long Term - mod. duration
EMU Govt, Long Term - mod. duration (fcm.)
EMU Govt, Long Term - mod. duration (fcs.)
EMU Govt, Long Term - mod. duration (fcw.)

100.00
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EMU Govt, Long Term
EMU Govt, Long Term - main scenario (fcm.)
EMU Govt, Long Term - strong econ. (fcs.)
EMU Govt, Long Term - weak econ. (fcw.)


Research Flash 9
Figure 9 shows that the different forecast yield paths lead
to different modified index duration profiles (lower forecast
index duration if redemption yields increase and vice versa),
which affects the total return calculation too. The different total
return components now allow a detailed decomposition of the
overall total return index forecasts across scenarios and hence
consistency checks. This is the main strength of the applied
methodology. Note that all pure fixed income indices, except
for the ILB and EM, are forecast with the methodology
outlined above.
This approach, however, requires that all the additional
index information necessary for the forecasting process is
available from the index provider. This data availability is e.g.
not provided for the Singapore government bond index data.
For Singapore government bond indices only redemption yield
and average duration of the index are available. The coupon
series is approximated via the redemption yield trajectory and
the average life of the index is not forecasted. Given these
limitations the forecasts have to be associated with a larger
degree of error compared to other index forecasts.

Government bond indices
Government bond indices (without a credit component) in the
CMA now include the BarCap US Treasury Bond intermediate,
BarCap US Govt Long Bond, Barclays EuroAgg 1-10Y
Treasury, Barclays EuroAgg 10Y+ Treasury, Citigroup WGBI
UK, CS LSI (Eidgenossen), the Citigroup WGBI Japan,
Citigroup WGBI Australia, the Bar Cap Global Government (ex
US) and now also the Singapore Government Bond (all
maturities) index.

Credit-related indices
Credit-related indices in the CMA include the BarCap US
Credit Bond 15Y, the BarCap US Credit Bond 510Y, the
BarCap US Corporate IG, the Barclays US HY composite and
the Barclays Pan-EUR Agg. HY. From the next CMA set
onward, we will stop forecasting the US credit indices and only
retain the US corporate index.
The Barclays Euro Agg. Corporate Index and the Credit
Suisse Liquid Swiss Index (ex-Eidgenossen) are also included.

Other indices
Other indices in the CMA include the BarCap Municipal Bond
1Y, BarCap Municipal Bond 1-10 year, the BarCap Municipal
Bond index, the Barclays US inflation-linked bonds TR index,
the Barclays Euro Government inflation-linked bonds TR index,
the Barclays EM World, the JPM GBI-EM Global Div., the
HSBC Asian Local Bond Overall and the ML Global 300
Convertible index. Our inflation-linked bond (ILB) TR forecasts
are computed as the sum of inflation expectations and real
yield-based total returns. The Barclays EM World TR forecast
is derived from relevant USD benchmark yield forecasts and
spread forecasts. Barclays EM World spreads are modeled in
a structural vector-auto-regressive framework against
fundamental variables such as GDP, debt/GDP, foreign
exchange reserves/GDP. For the ML 300 Convertible index,
we run multi-linear regressions against market factors and find
a robust statistical relationship between convertible bond
returns and equity, as well as US investment grade credit
returns. We thus estimate convertible bond returns based on
their sensitivities to equity and US corporate bond returns.
All forecasts are submitted to a qualitative consistency
check across asset classes and against the macroeconomic
teams long-term interest rate forecasts.
In emerging markets, we have modeled the EMBI+ total
returns using a two-stage approach. In the first step, we
forecast the spread component using the 10-year US Treasury
path forecast by our interest rate strategy team and the VIX
Index as a control variable to account for changes in investors'
risk preferences. We include a common variable across the
constituents of the EMBI+ to account for improvements or
deteriorations in the fundamentals for the asset class. In the
second step, we include our forecast EMBI+ as an exogenous
variable in Vector Error Correction model along with the
duration and yield of the EMBI+ to forecast the index.
Essentially, the model assumes that the duration and yield of
the EMBI will change according to their autoregressive history.
The model was tested on a performance basis across different
periods but we have also looked at how the index not only
predicted returns, but also changes in the duration and the
yield. With regard to local currency bonds (HSBC Asia local
currency and EM-GBI), we simply used the results from the
EMBI+ to forecast total dollar returns with a regression
analysis.

Research Flash 10
Equities
We use a two-stage dividend discount model that also
allows us to construct scenarios for different states of the
world.
The revision to our existing methodology brings together
the construction of the equity CMAs with our short- and
long-term index targets.

We forecast stock returns using the dividend discount model.
This has some important advantages, as it is not only intuitive,
but also applicable to a wide range of markets and investment
styles. It also allows us to incorporate variability in market
conditions, earnings growth and earnings levels into our
forecasts.
We compute equity returns through a three-step process:
we first employ a two-stage dividend discount model using
analyst consensus earnings to compute a market-implied
equity risk premium (ERP). We then compute an estimate that
we believe is warranted, given normal market conditions, to
calculate the projected total return over the next five years.
Finally, we use scenario analysis to stress test the level of
the total return for different states of the world.
The concept of the ERP is central to our methodology.
Simply put, this is the additional compensation equity holders
expect to receive for bearing more risk relative to risk-free
assets like government bonds. Many valuation models use
historic estimates of the ERP. The approach we favor,
however, is to estimate a forward-looking ERP, by equating
the current market level with consensus earnings estimates.
The advantage of such an approach is that it allows the ERP
to fluctuate as market expectations change. Moreover, it
allows us to gauge the impact of changes in market conditions
(approximated by Credit Suisse Risk Appetite Index and the
VIX) on the ERP by using regression analysis.
The dividend discount model assumes the value of a stock
equals the present value of expected dividends. As a first step,
we estimate dividends using market consensus earnings and
the historical payout ratio. The two-stage model is represented
by the following equations:

Index level
3
3
1
) 1 ( ) 1 ( r
value Terminal
r
Dividend
n
n
n
+
+
+
=
=

Terminal value
g r
g Dividend
+
=
) 1 ( *
3

Cost of equity ERP r r
f
* ) ( | + =

Index level represents the value of the index on the valuation
date, rf is the ten-year risk free rate, g is the growth rate in
perpetuity and is the systematic risk of the index (assumed
to equal 1). The growth rate in perpetuity is estimated using
weighted estimates of long-term domestic and international
GDP growth and the expected inflation rate. The weights of
domestic versus international growth depend on the exposure
of companies from each region to foreign markets. In the
previous sets of CMAs, we assumed international GDP growth
equals global GDP growth. For this set of forecasts, we
compute an export-weighted international GDP growth, where
weights correspond to the export share of different regions
vis--vis the domestic country or group of countries, and GDP
growth is equal to the regional growth as per the Credit Suisse
GDP projections.
Using the equations above, we determine the market-
implied ERP. We estimate the five-year forward return index
using the ERP under long-term average levels in volatility and
risk appetite.
Finally, using a regression model, we estimate the ERP for
+/ 1 standard deviation changes in volatility and risk appetite
(note that these two factors tend to move in opposite
directions). We also adjust the level of dividends according to
the relative size of nominal GDP in each year. For example, if
three years from today the level of GDP under the pessimistic
scenario is expected to be 10% lower than the main scenario,
we reduce the level of dividends by 10%. In addition, for the
optimistic / pessimistic scenarios we assume that the terminal
growth rate is 0.5% higher / lower than in the main scenario.
Figure 11 Figure 12
US market-implied discount rate Annualized expected return by region

6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
1995 1997 1999 2001 2003 2005 2007 2009 2011
S&P 500 implied discount rate Average
+1 St Dev +2 St Dev
4.0% 6.0% 8.0% 10.0% 12.0% 14.0%
Pacific ex Japan
Emerging Europe
ASX 200
Emerging Markets
Emerging Asia
Latin America
FTSE 100
DJ Eurostoxx
EAFE
World
S&P 500
Developed Markets
SMI
TOPIX 100
Expected return
Source: Credit Suisse Global Investment Returns Sourcebook 2010, Credit Suisse Source: Credit Suisse

Research Flash 11
Private equity and hedge funds
We employ a multiple linear regression model for
forecasting expected returns for private equity.
We employ a rolling multiple linear regression model in
combination with historical returns to derive our hedge
fund style return forecasts.

We use a weighted composite of the Cambridge Private Equity
(80%) and Venture Capital (20%) indices as a private equity
benchmark. Both the Cambridge Associates Private Equity
and Venture Capital Indices are quarterly series based on net
returns (excluding fees and expenses) of a large and
representative sample of US buyout and venture capital funds
since 1986. The smaller weight of the Venture Capital index
reflects the declining volume of assets invested in this
segment. The inclusion of venture capital translates into higher
return volatility for the composite index, but does not materially
influence our return forecast. For hedge funds, we use the
Dow Jones Credit Suisse (DJ CS) index family as benchmarks
to model hedge fund returns. The Dow Jones Credit Suisse
Hedge Fund Index is an asset-weighted index designed to
reflect as accurately as possible the hedge fund universe. It
includes ten primary subcategories based on at least 85% of
all assets under management. It is also widely considered as
one of the better performance benchmarks in the hedge fund
industry.
The different hedge fund style forecasts are based on the
underlying strategy forecasts and aggregated as follows:

Directional Style
o 50% Long Short Equity
o 50% Emerging Markets
Tactical Trading Style
o 50% Managed Futures
o 50% Global Macro
Relative Value
o 33,3% Fixed Income Arbitrage
o 33.3% Convertible Arbitrage
o 33.3% Market Neutral
Event Driven
o 100% Event Driven

In both alternative investment classes, a set of factors
(detailed in the sections below) tends to drive returns, and to
capture these we use multiple linear regression models to
forecast returns. This methodology also lends itself to the fact
that these alternative investments tend to be positively
correlated with current and lagged stock returns.
The general econometric model setup can be described by

where rt is the return of the corresponding index, the xk,t-i are
the K exogenous explanatory variables and |k,i are the
respective coefficients. The error term et is normally
distributed.

Private equity
In general, the business activity of a private equity fund lies in
investing in selected companies with the intention of
influencing investment and operating decisions. Target
companies are often restructured and resold through IPOs or
directly to a strategic investor (trade sale). Besides value
extracted through restructuring, the returns of private equity
funds are influenced by the timing of the initial investment and
of the divestment. Provided that private equity funds can buy
low and sell high returns should be positively correlated with
current equity prices and negatively correlated with equity
market returns in the previous 35 years.
We incorporate these facts as explanatory variables in our
private equity regression model. We use two different models.
One-quarter lagged total returns of the S&P 500 index are
included in both versions, while the second model additionally
includes the five-year lagged credit spread between the yield-
Figure 13 Figure 14
Realized and forecast total returns for a composite index
comprising Cambridge Private Equity and Venture Capital
indices (80% buyout, 20% venture capital).
Based on the strong opportunity set, private equity is expected
to deliver decent returns over the next five year horizon.
-40%
-20%
0%
20%
40%
60%
80%
100%
92 94 96 98 00 02 04 06 08 10 12 14 16
Historical private equity composite Index (80% CA Buyout, 20% CA VC)
Model 1 with equity return forecast
Model 2 with high yield - AAA spread and equity return forecast
Annualized returns in %
-30%
-20%
-10%
0%
10%
20%
30%
-
500
1'000
1'500
2'000
2'500
3'000
3'500
92 94 96 98 00 02 04 06 08 10 12 14 16
Quarterly Returns US Private Equity Composite Index (80% Buyout, 20% VC)
INDEX Quarterly returns
Source: Cambridge Associates, Credit Suisse

Source: The BLOOMBERG PROFESSIONAL service, Credit Suisse
), , 0 ( ~
2
1
, ,
0
0
o | | N e where e x r
t t
K
k
i t k i k
T
i
t
+ + =

=

=

Research Flash 12
to-maturity (YTM) on the Credit Suisse US High Yield Bond
Index and the yield on US AAA corporate bonds. This
additional variable aims to capture both the influence of
financing costs as well as the opportunity set of the initial
investment. All variables are modeled in terms of quarterly
percentage changes. We made conservative assumptions
about the level of alpha in the private equity industry, which
reflects our anticipation of a lower share of debt financing in
LBO transactions and lower top line growth than in the past
15 to 20 years. Our forecast is an average of the output of
both models.

Hedge funds revised methodology
The different hedge fund strategies can be described as
actively managed portfolios with different trading approaches.
Since all of them invest into traditional and non-traditional
assets, taking these underlying's as independent variables
makes sense from an econometric point of view and is a
widespread approach in empirical studies.
However, due to the low restrictions with regard to the
trading approach of hedge funds, portfolio exposures are
anything but stable over time. Assuming that current beta
exposures are stable over a horizon of more than 12 months
would thus not be appropriate. In the short run, most
strategies are highly affected by market liquidity, sentiment
and financing conditions. In the long run, hedge funds and
their underlying strategies are expected to deliver average
returns of around 10% p.a. (excluding index-related biases).
To take these short-term dispersions from the average
expected long-term performance into account, we will base
our five-year forecast on a 12-month short-term forecast in
combination with a four-year long-term return expectation
(which bases on rolling long-term averages).
The short-term (12-month) forecast is based on a 36-
month rolling multiple linear regression with strategy relevant
independent variables. We estimate average market
sensitivities of hedge fund strategy returns across the cycle
and combine the coefficient values with our five-year forecasts
for the corresponding market factors (equities, bonds,
commodities, etc.). For the remaining four years, rolling long-
term historical annualized returns are used. We take account
of index biases and adjust accordingly.
Finally, we aggregate the results of our style forecasts to
derive our expected broad hedge fund return expectations, in
order to maintain consistency with our style forecasts. The
different style returns are aggregated according to their latest
available index weighting within the DJ CS Hedge Fund Index.

Research Flash 13
Real estate
Our forecasts for the real estate indices are based on
multiple regression models.
The underlying economic model respects both the rental
and the capital market side of the direct real estate
market.

The objective is to form a replicable and robust forecasting
methodology for expected returns on real estate equity, fund
and direct market indices. In order to guarantee consistency
over the estimates, we use the same model-based forecasting
approach for all but one real estate index. However, we
consider the diversity of the property markets and of the
investment vehicles by allowing the set of explanatory variables
to differ across the indices.
For real estate equities, we use the regional sub-indices of
the GPR 250 Property Securities Index (source: Global
Property Research). The GPR 250 Index consists of the 250
most liquid property companies worldwide, and only uses the
tradable market capitalization of these companies as index
weights. The constituent property companies operate in a
variety of branches in the real estate universe: from senior
housing to warehousing, though most of them remain focused
on the classic business strategy of owning and renting office
space or residential properties.
The performance in Swiss real estate funds is represented
by the SWX Immobilienfonds Index. The index includes total
returns of all listed Swiss real estate investment funds,
weighted on the basis of their market capitalization. For
European property funds, we use the BAIF index for open-
ended real estate funds. This index consists of about 95%
direct market funds (i.e. funds that buy properties directly) and
5% real estate equity funds (i.e. funds that invest in real estate
equity vehicles). Unfortunately, the BAIF index only started in
2005. Due to the short data series, we assumed that the
funds follow the underlying direct market over the long term
and forecast the performance of European direct commercial
property markets as a proxy for the index return. As the
correlation between the index and the direct market
performance is not perfect, the forecast returns should be
taken with caution.
The US direct real estate market performance is measured
by the NCREIF Property Index. By capturing more than 12000
institutionally owned properties, the NCREIF index represents
the predominant index for US commercial real estate returns.
Yet, as it is an appraisal-based index, the NCREIF series tend
to lag the underlying direct market performance slightly.
Finally, the performance of Swiss direct real estate is
represented by the SWX IAZI Real Estate Performance Index.
We forecast total returns of all indices based on our
expertise of the underlying direct real estate markets. Total
returns on direct real estate indices are composed of net
operating income (e.g. rental income) and capital value growth
in the corresponding period. The former is mainly a result of
the current demand/supply imbalances on the rental market.
Capital value growth is, on the other hand, strongly driven by
the attractiveness as an investment destination. High-yielding
real estate markets should experience a yield compression,
following strong capital inflows. Higher expected rental growth
also leads to higher capital value growth. A good economic
model should take into account these factors contributing to
total returns.
We use a multiple regression model approach for all
indices. By linking the long-run performance of real estate
investments to the development of the underlying economy,
this methodology allows scenario analyses based on different
macroeconomic forecasts. The exact set of independent
variables depends on the specific index, but qualitatively does
not differ very much across the series. Real GDP growth is
used as a proxy for the strength of the demand side in the
rental markets.
To mirror the attractiveness of real estate investments in
capital markets, we take long-term government bond interest
rates and LIBORs as independent variables. Rising capital
market yields should reduce growth in property prices. In order
to explain the effect of inflation, CPIs are considered as
explanatory variables. For example, many commercial real
estate rent contracts provide direct provisions or indirect pass-
through channels tying rents to inflation. Superior inflation
protection is resulting over the long term and for direct
investments. In the estimations for the real estate equity
indices, we additionally control for the expected overall equity
market performances.
For the SWX IAZI Real Estate Performance Index, we first
forecast the price increase component of the total return and
then add an estimated income yield to that forecast. The
expected price increase is estimated by a multiple regression
model using GDP growth, long-term government bond yields,
construction activity, institutional investments, and stock
market performance as explanatory variables.

Research Flash 14
Commodities
As our primary approach to forecasting commodity index
returns, we employ a multiple linear regression model.
In addition to the econometric model, we apply a scoring
model as a consistency check and for scenario analysis.

The objective is to set up a systematic and robust
methodology to predict expected returns for the Dow Jones
UBS Commodity Total Return Index (DJ-UBSCITR) that are
consistent with the projected macroeconomic scenario. For
this purpose, we employ two forecasting tools: a multiple linear
regression model and a scoring model. We use the regression
model as our principal forecasting approach and the scoring
model as consistency check.
The DJ-UBSCI is designed to be a liquid and diversified
benchmark for commodities as an asset class. The DJ-UBSCI
is composed of futures contracts on 20 physical commodities
across all sectors. The component weightings are determined
once a year and depend mainly on relative trading liquidity and
dollar-adjusted global production. All data used in both the
liquidity and production calculations is averaged over a five-
year period. In order to ensure enough diversification, lower
and upper limits are given for individual and selected
aggregated weights. No single commodity can contribute less
than 2% or more than 15% to the overall index. In addition, no
commodity sector (e.g., energy, precious metals, livestock or
agriculture) can represent more than 33 % of the index. The
DJ-UBSCI is reweighted and rebalanced each year in January.
The index is available on a daily basis and quoted in USD.
Besides the DJ-UBSCI, the DJ-UBSCI family of indices also
includes a total return index based on the DJ-UBSCI (the DJ-
UBSCITR). The latter reflects the return on a fully
collateralized investment in the index and serves as a
dependent variable in our forecast estimations.
We forecast our total return values with a multiple linear
regression model using following equation:

where trt is the total return of the DJUBSCITR Index, xn,t is the
n-th explanatory variable and |t are the respective coefficients.
The error term et is normally distributed.
The DJ-UBSCITR has three different sources of return.
The first and most important source is the change in spot
prices of the constituent commodities. The second return
source is the so-called roll yield. The index mirrors the
performance of front month commodity futures prices.
However, as these futures approach their expiry date, they
need to be sold with the proceeds then reinvested in the
subsequent futures contract a process called rollover. Since
the subsequent contract usually has a different price than the
expiring one, rolling costs/rolling yields arise. The third source
of return is the yield on the collateral. Commodities are traded
via margin accounts. That means in order to gain exposure of
a certain dollar amount in commodities, one has only to invest
a fraction of this dollar amount in commodity futures. In a fully
collateralized investment strategy, which is the case in the
index, the capital not invested in futures is invested in fixed
income securities. These securities also generate a certain
return, which is the third return source for the index. An
econometric model needs to capture all three return sources in
order to be able to produce reliable forecasts. In our case, the
model employs global industrial production, inflation pressure,
US 10-year yields and US oil inventories as explanatory
variables.
Global industrial production and US inflation pressure are
used in order to capture expected spot price movements. Spot
price fluctuation is very sensitive to economic growth rates and
deviation from trend. Both variables correlate highly with
commodity spot price changes. We use commodity inventories
to capture expected roll yield. The term structure of commodity
futures markets and therefore the roll yield largely depend on
the economics of storage, for which inventories are a good
Figure 15

Figure 16
Econometric output for the DJ UBS Commodity Index fair
value estimation

Scoring model for the DJ UBS Commodity Index

-100
-80
-60
-40
-20
0
20
40
60
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Dow Jones UBS Commodity Index Model
YoY changes
in sample
estimation
out-of-
sample
forecast

0
50
100
150
200
250
300
350
400
450
500
0
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
Jan 95 Jan 97 Jan 99 Jan 01 Jan 03 Jan 05 Jan 07 Jan 09 Jan 11
Strategy I (applyingfixedin-samplecorrelations)
USISMManufacturing Index
3Maverage of 6Mchanges in outstanding futures and options of commodities traded on USexchanges
Oil Futures Curve Spread 3Maverage
Third Moment of DJUBSTR
6Mchange of real yield (3MLibor - USCPI)
DJUBSTRIndex (RHS)

, ...
, , 1 1 0 t t n n t t
e x x tr + + + + = | | |

Research Flash 15
proxy. In an environment of falling inventories, commodity
markets are usually in backwardation and generate positive roll
yields. US 10-year yields are used to capture the return on the
collateral. Usually the collateral is invested in US T-Bills and
bonds. The return on the collateral therefore largely depends
on US interest rates.
The dependent variable, as well as global industrial
production and inflation pressure, are modeled in terms of
year-on-year changes. Oil inventories are modeled as deviation
from the 5-year average. US 10-year yields are taken in their
original form. The results for the fair value regression model
are encouraging. The estimated coefficients are all significant
and have the correct sign. The regression has an R-squared
of roughly 0.71. The Durbin-Watson statistic is around 0.5,
which indicates the presence of some form of autocorrelation.
Nevertheless we restrain from adding autoregressive terms.
Since the purpose of the model is forecasting, we try to keep
it as parsimonious as possible. To illustrate our forecast
accuracy, we plotted actual and predicted in-sample and out-
of-sample patterns of the DJ-UBSCITR (Figure 15). The
coefficient estimates of the model are fairly stable over time.
As a result, the out-of-sample performance looks very
promising. One needs to note, however, that we are giving the
model an unfair advantage, as we use ex-post data for our
out-of-sample forecasts. In reality, we are using ex-ante
forecasts for the explanatory variables as inputs for the model
forecasts. Consequently, the forecast accuracy of the model
will largely depend on the forecast accuracy of the inputs.
Given that the model forecast is derived directly from the
macroeconomic input, expected returns are consistent with the
macroeconomic scenario. However, the forecast is not very
robust. Minor changes to one or several input variables could
potentially lead to large changes in the output of our model.
In order to overcome these potential problems with the
robustness of the model, we have developed a scoring model
for the DJ-UBSCITR that also includes indicators which are
excluded from the econometric model due to multi-collinearity.
A scoring model is a procedure to evaluate alternatives by
considering a wide range of quantitative and qualitative
characteristics. The individual indicators that make up the
score are weighted according to their correlation with the
index. The scoring model assesses how accommodative the
environment is for commodity investors. A score above the
back-tested threshold of 0.4 indicates a supportive
environment with positive returns. Figure 16 shows how the
scoring output illustrates the contributions of the individual
indicators to the overall score. This scoring model is used for
scenario analysis to check the robustness and the consistency
of the forecasts of the econometric model.
According to our own experience, the two models tend to
deliver quite similar results, which is encouraging. However, if
there is an inconsistency in the output of these two models,
we would give more weight toward the output of the
regression model in the final forecast in order to ensure that
the numbers are consistent with the overall economic scenario.

Research Flash 16
Gold
Gold is particularly hard to value as it generates no cash
flows that can be discounted and has only limited
applications in the real economy.
We use a fair value approach based inflation, foreign
exchange movements and real interest rates.

Computing expected returns for gold is particularly challenging
due to the specific characteristics of gold as an investment.
First, gold is a non-yielding asset, i.e. a gold investment yields
no interest or dividend payments that can be discounted to
arrive at a fair value. Second, gold has in contrast to other
commodities only limited applications in the real economy.
That means gold prices react far less to changes in global
economic growth than other commodities, making it more
difficult to model gold price changes based on economic
factors. Third, gold can be recycled almost indefinitely. In
principle, all gold that was ever mined is still available as gold
bars, jewelry or central bank reserves. The World Gold Council
estimates that total above ground stocks of gold are sufficient
to cover global gold demand for about 45 years. For other
commodities such as oil or base metals, total above ground
stocks only cover several months of demand. That means
changes in availability and inventories which are important
drivers for other commodity prices have only little influence on
gold prices. Fourth, gold is often used as a safe-haven asset
during geopolitical and financial crises, which are hard to
model in a systematic way and can generate significant price
shifts in the gold market.
Despite these challenges, there are several generally
accepted factors that have a systematic influence on gold
prices. Gold is a reserve asset of central banks. And despite
the fact that the gold standard has been abandoned since the
1970s, gold is still seen and used as a long-term hedge
against inflation. Similarly, gold is often seen as an alternative
currency. Therefore gold prices have a significant and at
least over the long term stable correlation with the internal
and external value of the US dollar. Apart from that, there is
also a link between gold and the absolute level of interest
rates. As a non-yielding asset, interest rates are the
opportunity costs that an investor incurs when investing in
gold. In this regard, rising interest rates should have a negative
effect on gold prices.
In order to calculate expected returns for gold, we use a
regression model that combines all of these factors. The
model is estimated using quarterly return data for gold with the
following formula:

In this formula
t
r denotes the yearly return of the gold spot
price in quarter t. Since investors can buy gold physically, we
directly model the expected return for spot prices.
0
| is a
constant. Variable xn,t is the n-th explanatory variable in period
t and |t are the respective coefficients. The error term et is
normally distributed.
The constant can be interpreted as trend return. The
economic explanation for a trend return relates to a long-term
increase in demand. As total wealth grows and investors keep
a certain percentage of their portfolios in gold, gold demand
grows at a certain rate regardless of fundamentals. This has
implications on the price. The trend yield is statistically
significant and positive. The other explanatory variables we use
are US 2-year real government bond yields, quarterly changes
of inflation and the USD Index. High inflation rates and USD
depreciation should lead to positive gold price returns, while
higher interest rates should lead to lower gold returns. All
variables in the regression are highly significant and have the
correct sign. The regression has an R-squared of roughly
0.64. The Durbin-Watson statistic is 1.78, which indicates the
presence of some form of autocorrelation. As in the model for
the DJUBSTR, we refrain from adding autoregressive terms.
Since the purpose of the model is forecasting, we try to keep
it as parsimonious as possible. Using the fitted returns of the
model, we compute a historical time series of fair values for
the gold price. The starting point for the computation of the
historical fair values is derived using an optimization process.
The starting point is chosen such that the squared deviation
between the true historical gold price and the fair value is
minimized.
Using the forecasts of our economics team as input, the
model can derive expected returns for gold, which we use to
project the fair value for gold. We assume that the gold price
will converge from current spot to the projected fair value over
the forecast horizon and in this way derive expected returns for
gold from current spot levels.

Figure 17
Fair value for gold prices
0
500
1'000
1'500
2'000
2'500
76 80 84 88 92 96 00 04 08
01.07.2012 +1Stdev -1Stdev Fair value Gold
USD/oz
, ...
, , 1 2 1 , 1 1 0 t t n n t t t
e x x x r + + + + + =

| | | |

Research Flash 17
Foreign exchange (FX)
Depending on the decision of whether to hedge currency
risk on a systematic basis, 5-year currency forecasts may
be required.
We base our long-term FX forecasts on the current fair
value estimate given by the Credit Suisse Fair Value
(CSFV) model.
Directional indications from the CSFV model are
calibrated according to historical volatility. We also take
the economic, interest-rate scenario as well as technical
indicators into account.

In our 2012 Credit Suisse fair value update, we have re-
estimated our long-term equilibrium exchange rate model,
extending the sample period from 19802006 to 19802010.
We find that the inclusion of recent observations resulted in
meaningful impacts on the model parameters and regression
results.
We have made two significant modifications to the existing
model.
First, we have removed the net investment income (NII)
variable from the model, as it has lost statistical significance
and would now be incorrectly signed. We acknowledge that
the extreme volatility in the NII variable in 2008 and 2009 has
impaired the variables usefulness in explaining currency
movement. We originally used NII as a proxy for net foreign
assets, for which purpose it should be relatively stable. The
extreme volatility seen since 2008 is not a meaningful
reflection of net foreign asset positions and so it is
understandable that the variable is no longer consistent with
our intention. While exclusion of the NII component simplifies
the model, we retain a clear external balance component in the
form of the trade balance. The trade balance term has also
suffered some heightened volatility in recent years, and lost
some significance, but the coefficient remains both
statistically-relevant and theory-consistent. All other variables
relative price levels (PPP), yields and productivity all retain
significance and theory-consistency.
Second, as we now have a significant number of post-
EMU years in our dataset, we need to control for the pre- and
post-EMU environment. Although explanatory variables in
Eurozone members retained a significant certain degree of
fluctuation post 1999, the independent variables are
essentially all identical thanks to the introduction of the euro in
each country. The use of a semi-truncated dataset, via dummy
variables, mitigates the problem of under-estimation bias
induced by limited variation in the currency movement for the
Eurozone members in our panel.
With these two modifications, we estimate our long-term
exchange rate equilibrium values with the following equation:

s = a + b1 (p-p*) + b2 (R R*) + b3 (gdppc gdppc*) + b4
(BAL BAL*) + e

where s is USD per unit of home currency, p is the home price
level as measured by GDP deflator, R is the 10-year bond
yield, gdppc is real GDP per capita (a proxy for productivity),
BAL is the goods and services trade balance as percentage of
GDP, and e is a random error term. Lower cases indicate data
are in logarithmic terms, and * indicates a foreign variable,
which in each case here is the US.

In Table 1 we display the estimated long-run coefficients
(representing the long-term elasticity of the nominal exchange
rate with respect to each variable). The estimated coefficients
are signed and sized in accordance with expectations.

We note that the explanatory power of the PPP and yield
differential remains strong, and is highly significant. At the
same time, the relative productivity variable also gained
explanatory power in explaining currency movement. However,
the usefulness of external balances in explaining FX has
weakened substantially. Although the coefficient on trade
balance remains statistically significant, its magnitude has
been largely reduced. Overall, we think the inclusion of recent
observations resulted in meaningful impacts on the model
parameters and regression results. This is partly due to the
sharp fluctuation in exchange rates, as well as market and
macroeconomic variables, recorded throughout the 2008
2010 turbulence period. In addition, the recent observations
also feature new risk factors, such as a sovereign credit and
liquidity risk premium, heavily influenced market variables and
currency market price action.
The PDOLS estimation also generates a set of powerful
short-term dynamics, which capture the simultaneous, and
potentially endogenous, interaction between the nominal
exchange rate and the different macroeconomic variables, and
help address the issue of serial correlation in the residuals. At
the same time, they add some dynamics to our long-term fair
value, enhancing the usefulness of the fit of our estimates.
The model also estimates country-specific intercepts,
which effectively rebase each exchange rate, such that the fair
value is on average equal to spot over the sample period. The
extension of the sample period has, therefore, affected the fair
value estimates, making the fair value more in line with the
spot rate in the sample. In most cases, this had a marginal
impact.
Table 1: FX Fair Value
2012 estimation
PPP -0.81
t-stat -14.45
p-value 0
Yield differential 4.6
t-stat 8.51
p-value: 0
Relative productivity 0.77
t-stat: 4.57
p-value: 0
Trade Balance: 0.69
t-stat: 2.17
p-value 0
R-squared adjusted 0.996

Research Flash 18
For details on the CSFV model, see Research Alert
Foreign Exchange Equilibrium exchange rates: Our fair value
update for 2012" by Joe Prendergast, 12 June 2012.
Figure 19 illustrates the development of the EUR/CHF
exchange rate and its fair value. The EUR/CHF exchange rate
is at present significantly below its current fair value, having
been significantly over-valued in recent years. EUR/CHF fair
value is expected to continue trending slightly lower over time,
but CHF no longer yields any significant long-term expected
return as the EUR over-valuation has been erased.
Figure 18

Figure 19
Example: Against the background of the US current account
deficit, the USD needs to have an interest rate advantage of at
least 300 bp to appreciate against the CHF over the long run.

Example: Estimated fair value and the actual exchange rate
pattern of EUR/CHF.

1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
Jan 82 Jan 86 Jan 90 Jan 94 Jan 98 Jan 02 Jan 06 Jan 10
26.06.2012 +1 Stdev -1 Stdev Fair value EUR/CHF
EUR/CHF


Research Flash 19
Volatility forecasting
Methodological introduction
1. Definition of volatility: As there are different ways to
compute historical volatility, we refer to volatility as the
standard deviation of monthly returns of an asset class. All
monthly volatilities are annualized.
2. Autocorrelation of returns: when asset returns exhibit
autocorrelation, i.e. are statistically dependent on past
returns, the volatility as defined above tends to
underestimate the true return volatility. Literature proposes
several methods to adjust for this effect, of which we now
implement two: the Fisher-Geltner and/or the
autocorrelation adjustment proposed by C. Alexander
3
on a
systematic basis.
3. Volatility clustering: Historically, volatility across financial
asset classes tends to mean revert over time but different
degrees of autocorrelation and sometimes clustering. A
simple approach to long-term forecasting of volatilities would
consist in taking simple long-term historical averages as an
approximation of the unconditional mean volatility. In some
cases, however, this can lead to the underestimation of
volatilities due to the clustering and high autocorrelation of
volatility in some asset classes. In those cases, using models
that can properly capture the dynamics of volatility over time
induces lower forecasting errors. Among the various
modeling avenues tested in the past, including different
variants of Garch, Arch, t-Arch and Ornstein-Uhlenbeck
processes, the Ornstein-Uhlenbeck model was found to
produce the most convincing out-of-sample forecasting
results in those cases where strong volatility clustering was
observable. In the CMA, we in general retain the long-term
historical mean corrected for auto-correlation. When there is
evidence of strong clustering end-of-sample, we do
compare on a case by case with Ornstein-Uhlenbeck model-
estimates and apply a judgmental overlay for final forecasts.

3 Quantitative Methods in Finance, p. 259, Carol Alexander, Wiley & Sons, 2008
The Ornstein-UhIenbeck process
The Ornstein-Uhlenbeck (0-U) mean reverting stochastic
differential equation is:

where q denotes the speed of reversion, x
m
the mean value to
which the process returns in the long run, and o the diffusion
term volatility.
Notice that the mean reversion component is governed by
the distance between the current xt (i.e. current volatility) and
the long-term mean x
m
as well as by the mean reversion rate
q. If, for example, current volatility is above the mean reversion
level, then the mean reversion component will be negative and
thus the volatility is more likely to fall than to rise in the next
period. This process results in a volatility pattern that drifts
towards the mean reversion level, at a speed determined by
the mean reversion rate.
The 0-U continuous time equation is a first-order AR(1)
process, making it possible to estimate the parameters of the
continuous time process from discrete time data. The discrete
representation of the 0-U process can be formulated as

where alpha and beta are the regression parameters. Our
forecast volatility path will be based on the continuous time
equation, but the process parameters will be determined by a
regression analysis of the discrete process using the historical
time series.
For the sake of completeness, it should be mentioned that
the O-U process allows values to become negative. In terms
of forecasting volatilities, this is nonsensical (volatilities cannot
be negative). To avoid negative volatility over the long run, the
following condition has to be satisfied:

The forecasting procedure
The forecasting procedure goes as follows:
First, generate a series of historical volatilities for each
asset class.
Second, compute adjusted historical volatilities for return
autocorrelation, which biases to the downside the volatility
measurement this is essential for alternative asset
classes.
On a case by case basis in the presence of strong end-
of-sample clustering, estimate the O-U process
parameters out of the historical volatilities. Then calculate
forecasts using the estimated underlying 0-U process
with current volatility as a starting point. We average our
predicted volatilities to obtain an average for the next five
years.
Fourth, where necessary, apply a qualitative judgmental
overlay to determine which volatility measure (historical,
historical and adjusted for autocorrelation, O-U process)
best reflects the volatility of each asset class over the
forecast 5-year horizon.

In most cases, we find that historical volatility adjusted for
autocorrelation provides a good guidance for future volatility.
Figure 20
Example: Predicted volatility for GPR 250 US Index
0%
5%
10%
15%
20%
25%
12/91 12/95 12/99 12/03 12/07 12/11
Volatility Series GPR 250 US Index
Historical avg.
-/+ 1 std. dev. from hist. avg.
Long-term-avg. mean reversion
+1STD forecast error
O-U forecast value
-1STD forecast error
Average vol over 5Y horizon
0%
5%
10%
15%
20%
25%
12/91 12/95 12/99 12/03 12/07 12/11
0%
5%
10%
15%
20%
25%
12/91 12/95 12/99 12/03 12/07 12/11
Historical avg.
Historical avg.
O-U forecast value
O-U forecast value
), 1 , 0 ( ~ with
1
N x x
t t t
c c | o + + = A

( ) ), 1 , 0 ( ~ with N dt dt x x dx
t t
m
c c o q + =
. * 5 . 0 * o q > x

Research Flash 20
Special focus: Testing and estimating structural breaks
in EM equity index volatilities
Qualitative evidence suggests that emerging markets (EMs)
have gone through a transition during the last decade
(especially after the Asian crisis in 1998), which has led to a
gradual convergence in governance, management, risk
control, etc., by many EM corporates to developed market
standards. Our assumption is that this process also has an
impact on the volatility of EM assets, in particular EM equities.
Provided evidence is found for a structural break in emerging
market equity risk, if this break is not accounted properly, an
overestimation of expected volatility for EM investments could
result. In order to examine the existence of these two regimes,
we have conducted several econometric tests, which help to
put this adjustment into a tractable framework. The adjustment
(test) procedure is summarized below:

1. Hypothesis: Emerging market equity volatility experienced
a structural break during the last decade
2. Search for possible break points
3. Test possible break points
4. Formulate GARCH-based model that accounts for a
structural break variable in the GARCH equation
5. Calculate unconditional (long-term) volatility based on
these GARCH estimates and compare them with the
unadjusted unconditional volatility of the GARCH
estimates

An illustration of the hypothesis for a structural break in the
equity volatility series for EM is shown in Figure 21 below.
Volatility was lower for all the tested major EM equity indices
measured between 1998 (Asian crisis) and the end of 2007,
compared to the sample (19911998), whereas the volatility for
the S&P500 index shows the opposite development.
In order to confirm the hypothesis, we have run simple
regressions on squared log returns (the approximation for the
one period variance) of the EM equity indices in question
relative to squared log-returns of the MSCI world equity index.
( ) ( )
2 2
World MSCI log log A + = A | o y

This equation is tested using the Quandt-Andrews test for
unknown break points in order to receive an estimate of possible
time breaks in the squared return pattern relation between
emerging markets and global equities. The estimated possible
break points are tested additionally with the Chow break-point
test to confirm the findings of the Quandt-Andrews test. The
results for the major EM equity indices are shown in Table 2
below.

The break-point tests confirm our hypothesis that, relative
to the global equity markets, a shift in regime between 1997
and 1999 for EM equity volatility (represented here as squared
log-return series) has occurred. With these results in mind, we
have specified GARCH-based return regressions with and
without incorporating a time dummy variable in the GARCH
diffusion. Both specifications allow us to calculate
unconditional long-term convergence levels for volatility (similar
to the Ornstein-Uhlenbeck approach) and compare the results
of the dummy-adjusted and non-adjusted specification. The
time dummy (our estimated breakpoint that is representative
for all the EM equity indices) is equally set for all EM equity
indices at October 1998.
Based on these results, we take the view that a correction
must be applied to historical volatilities to estimate future
volatility more accurately. Correction values as per Figure 22
are hence used to adjust the current (data between 1991 and
today) estimated long-term volatility for EM equity indices.
Autocorrelation is also accounted for as for all other indices.
Figure 21
Historical volatility of major EM indices along with S&P 500
measured as annualized standard deviation of log-returns.
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
MSCI EM
Tot al
MSCI
Asi a e x.
Japan
MSCI EM
Asia
MSCI EM
Eu rope
MSCI EM
Lati n
Ame ri ca
S&P500
S
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n

i
n

%
1991-1998 av g. 1998-2008 avg .
1991-2008 av g.
Table 2: Breakpoint test results for EM indices
MSCI EM
Total
MSCI EM
Asia
MSCI EM
Europe
MSCI EM
Latin America
Quandt-Andrews
unknown breakpoint
test:
1999M12 1997M08 1998M09 1998M09
Chow break-point test
(p-value):
0.0000 0.0016 0.0000 0.0000
Figure 22
Adjusting EM equity return volatility

0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
uncond.
GARCH(1,1) with
dummy 1998
uncond.
GARCH(1,1)
without dummy
1998
correction of
vol atilty history
due to structural
break
MSCI EM Total MSCI EM Asia
MSCI EM Europe MSCI EM Latin America
L
o
n
g
-
t
e
r
m

e
q
u
i
t
y

v
o
l
a
t
i
l
i
t
y
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
uncond.
GARCH(1,1) with
dummy 1998
uncond.
GARCH(1,1)
without dummy
1998
correction of
vol atilty history
due to structural
break
MSCI EM Total MSCI EM Asia
MSCI EM Europe MSCI EM Latin America
L
o
n
g
-
t
e
r
m

e
q
u
i
t
y

v
o
l
a
t
i
l
i
t
y

Research Flash 21
Correlation matrix
Computing a covariance/correlation matrix is fraught with
several statistical problems and, in this section, we outline two
key adjustments we make in computing a correlation matrix for
the 78 asset classes.

De-smoothing of returns
An appraisal valuation approach is used to measure the
performance of several illiquid asset classes such as direct real
estate and private equity . Appraisal performance
measurement artificially smoothes the return pattern of a time
series which leads to auto correlated returns and an
understatement of the true return volatility. In our specific
project, we had to deal with auto correlated returns in the case
of private equity and direct real estate. We addressed this by
de-smoothing the return for private equity, hedge funds as well
as direct real estate with the popular Fisher-Geltner method,
which is based on a AR1 process, to remove the
autocorrelation of returns and therefore to estimate the true
volatility of the asset class.

Stambaughs method: Harnessing the information
contained in time series with long histories
The first problem arises from having to compute the correlation
matrix with time series of varying time length. The simple
approach (truncated estimation) would consist in computing
the correlation matrix based only on the common history. This
would lead to drastic information losses, as the shortest time
series (the BBUOREAL Index) starts in January 2005. We
would thus lose useful information contained in the longer
series, and the matrix would be conditioned by the
characteristics of a short history sample resulting in an
elevated estimation error of the parameters.
The Stambaugh
4
method strives to combine the
information available in long history data with that of shorter
history assets. For instance, suppose that we have two assets,
J and K, J having a longer history than K. The moments of
asset K will be estimated through a linear regression, the
magnitude of this extra information being defined by the
sensitivity (beta factor) of asset K relative to asset J
movements over their common history sample. The missing
data is thus estimated in a recursive way. The missing data of
the longest incomplete times series is estimated first. We then
successively measure the sensitivity of each shorter series
against the longer ones with a multiple linear regression and
estimate their historical behavior. The modeling of missing data
thus allows us to calculate a covariance matrix, which includes
the information present in long history series.

4 Covariance Misspecification in Asset Allocation, Steven Peterson and John Grier,
Financial Analyst Journal, 2006.
Shrinkage method
Now that we have calculated the covariance/correlation matrix,
the next issue to address is minimizing the estimation errors
contained in the matrix. Standard statistical theory assumes
that the real world outcome we observe in a time series
constitutes only a sample of an invisible data generating
process we try to estimate. Since we do not know the true
underlying data-generating process and can produce only
noisy estimates of the correct volatilities and correlations, the
optimization output is usually biased. An ex-ante optimal
portfolio construction can turn out to be quite inefficient with
the benefit of hindsight. As Michaud put it, portfolio optimizers
are in practice often great tools to maximize estimation errors
with usually dire consequences for the nave asset allocator.
Outliers and extreme values in the covariance matrix can
lead to the construction of inefficient portfolios. Though
extreme correlations can truly reflect the dynamic between two
asset classes, they often originate from bad data or sample
bias. On the one hand, an asset with a low correlation could
be assigned a disproportionate weight, while on the other, high
correlations could displace other asset classes in the portfolio.
The shrinkage method represents a common way of reducing
estimation error. All matrix values are shrunk toward central
values through a linear combination of the sample value and a
target value. The choice of the shrinking factor (o factor in the
equation below) reflects the intensity and the degree of
uncertainty we have to deal with
5
. If we assume for instance
that the dataset is quite noisy, we might decide to give a
weight of 50% to some target value and place a weight of
50% on the sample values.

S F
Shrink
) 1 ( c + c =

From the above formula, the new correlation matrix E, is a
combination of F, the Stambaughs correlation matrix, with S,
the prior matrix. S is the matrix used to shrink the correlation
toward more central values. To compute the target matrix S,
we first define five broad asset groups that exhibit similar
statistical behaviors:

1. Equities: This encompasses traditional equity indices and
in addition the BXM Call Write Index as well as the BoA
ML Convertible Bond Index.
2. Bonds: This category includes both government bonds
and credit market instruments.
3. Cash, which encompasses all local cash Libor indices.
4. Real estate, which includes the G250 index family and
the ZKB Immofond index for listed real estate as well as
the NCREIF index for direct US Real Estate.

5 The statistical intuition behind the shrinkage method and its empirical benefits will
not be discussed here further. Interested readers should refer to papers on the
James-Stein estimator.

Research Flash 22
5. Commodities, which constitute a stand-alone block, as
the DJ-AIG index is uncorrelated to all other asset
classes.
6. Forex, which constitutes all Forex pairs.
7. Hedge funds and Private Equity, including the four
different hedge fund sub-styles.

We compute an equally weighted average correlation within
each asset group and, in a similar way, average cross asset
group correlations between the seven asset groups.
Consequently, the prior matrix S is composed of 49 blocks.
These average values are then slightly adjusted, based on
qualitative judgment to better reflect future expectations of co-
movement between these asset groups.
We use a Ledoit/Wolf
6
algorithm to compute the shrinkage
factor, leading to a current value of 0.17 (0.52). We then
apply this shrinking factor to the two matrixes, F and S, as
described in the equation above.

A brief summary
We compute a correlation matrix, with all the available history
of long time series, using the Stambaugh algorithm. We then
apply the shrinkage method to reduce estimation error in
calculating the correlations while taking into account the
different correlation patterns between major asset groups such
as bonds and equities. We combine a prior matrix with the
Stambaugh matrix by reckoning a shrinkage factor. The result
is a well-behaved correlation matrix with reduced estimation
error.
The conditional number of a matrix gives us information
about the quality of the matrix. According to Ledoit, high
numbers (higher than 100,000 reflect a nearly singular matrix)
point to unreliable territories, and low numbers, around 100,
point to reasonable values.
The Stambaugh matrix had a condition number of more
than 50,000, but this number plummets to about 100 after
the shrinkage, comforting us in the use of the method and the
computation of the new matrix.

6 Honey, I shrunk the covariance matrix. Olivier Ledoit and Michael Wolf, November
2003.

Research Flash 23

Imprint
This publication has been authored by Private
Banking Global Research
US Contact Information
Investment Strategy and Advisory:

Barbara M. Reinhard, Chief Investment Strategist
Managing Director
Tel. +1 212 538 7604
E-mail barbara.reinhard@credit-suisse.com

Philipp E. Lisibach, Director
Tel. +1 212 538 0311
E-mail: philipp.lisibach@credit-suisse.com

Jimmy James, Director
Tel. +1 212 538 5944
E-mail: jimmy.james@credit-suisse.com

Samuel Baumann, Assistant Vice-President
Tel. +1 212 538 5194
E-mail: samuel.baumann@credit-suisse.com

Scott Rosenblatt, Assistant Vice-President
Tel. +1 212 325 4458
E-mail: scott.rosenblatt@credit-suisse.com

Ryan Sullivan, Assistant Vice President
Tel. +1 212 538 2194
E-mail: ryan.sullivan@credit-suisse.com

Research Flash 24
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New York, 5 July 2012

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