Tactical Asset Allocation: Predictability of Capital Markets Using Error Correction Models - Proceedings AFIR 1996 - Nürnberg, Germany

How to optimize returns of an international equity or bond portfolio? Which bets should we make between bonds and stocks on a domestic balanced portfolio? Access to capital markets has become increasingly easier for investors. In this context, the Tactical Asset Allocation (TAA), which refers to how a portfolio's funds would be allocated, given the investor's short-term forecasts, is an essential step in the management global process. Building market valuation instruments in order to identify opportunities will be the point of departure for TAA. This paper introducts the evaluation models developed by CCF Structured Asset Management, CCF 's quantitative asset management subsidiary. These techniques cover the bond and equity markets of a group of industrialized countries. The approach involves the search of an "equilibrium" or "fair price" based on long term relationships between market prices and a set of explanatory variables and the identification of error correction mechanisms which drive observed market prices to equilibrium market prices. Model specifications have taken into account the global aspect of international economies and financial flows. In particular, the leadership of the United States, Japan and Germany are considered. The results allow for the estimation of fair prices for each market, consistent with a general financial equilibrium. Deviations from equilibria are observed, which are indeed submitted to mean reversion forces, ensuring market efficiency in average. Tactical asset allocation will exploit arbitrage apportunities offered by deviations from the fair price. Cointegration techniques have been used in model's estimation. Examples of applications using model forecasts and optimization techniques are also presented.