Annual Forecast

8/12/2019 Annual Forecast

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Chapter1.

Chapter2.


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Lessons from the global crisis: The valuation of financial assets

under highly liquid conditions, and the appearance of more

frequently occurring extreme risks than in previous decades, has

led to a particularly unusual market context, that makes more

relevant the derivatives market and hedging instruments.

After the financial crisis, the relationship between the interest rateswap government debt markets underwent a structural change,

especially with respect to long-term contracts, which demonstrated

the excessive demand for "low risk" assets.

Given the more challenging economic and financial environment,

the volatility hedge tools VIX and VXX, as well as those for

interest rates (interest rate and/or exchange rate swaps) are

progressively more relevant within risk and portfolio management

by market agents.

The development of the local interest rate swap market will

continue to gain relevance. This places their understanding,

accurate valuation methods, and analysis on the frontier of

development not only for the local but also for other capital

markets in the region.

Brian Lesmes

Economist specialized in Central Banks

and Financial System

[email protected]

(571) 353 6.600

Andrs Ortiz

International Manager of the EconomicResearch

[email protected]

(+571) 353 6.600

Juan Pablo Espinosa

Head of Economics and Fixed-Income

[email protected]

(+571) 353 6.600

http://investigaciones.bancolombia.com

Bloomberg: BCLB and VBCL

January 30, 2013


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Figure 1. Evolution and volatility of the VIX

Source: Bancolombia, Bloomberg.

Figure 2. Comparison between the S&P 500 index and

the replication index with hedges against extreme

risks of losses.


After the global crisis between 2008 and 2009, the world

economic environment underwent a series of changes, in

which higher uncertainty with respect to the behavior of

financial assets, among other things, is notable. The

methodology of measuring risk, the valuation of assets in a

highly liquid environment underpinned by the main

developed countries central banksand the appearance of

more extreme risks occurring more frequently than in

previous decades, have led to a particularly unusual market

context that is unprecedented in recent economic history.

The VIX is an index that uses the options market to measureexpectations of future volatility in the US stock market

reference index (S&P 500, Standard & Poors) and it is widely

used as a risk aversion barometer. The higher the index, the

higher the risk aversion; inversely, a lower level shows a lower

perception of risk. In the midst of international financial

turbulence, when the VIX recorded its historic highs, another

index was introduced: VXV, which represents or indicates

volatility expectations for market volatility (VIX). (See Figure

1).

This financial innovation reflected the interest of asset

managers to hedge risks that occur infrequently but have a

high impact on their portfolios, which is known as tail risk

(see Figure 2). The tracking of these indices has become a

constant for monitoring situations in which financial tensions

due to the economic crisis may give rise to unanticipated

losses in portfolios, and are becoming more relevant in the

vocabulary of professionals and financial market experts. The

existence of these exposures also reveals the importance of

using novel financial instruments, as a tool for efficientlymanaging those risks.

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Figure 3. Swap spread in the United States (Measured

in basis points - bp)


Hence the relevance of the derivatives market and hedging

instruments.

Apart from extreme volatility, another important aspect to

note throughout the last few years is the behavior of the

relationship between the interest rate swap market and the

government bond market. This relationship, called swap

spread, measures the difference in basis points between the

fixed interest rate leg of a derivative contract/hedge fixed to a

floating rate leg (tied to a reference indicator) and a US

Treasury bond with the same maturity (benchmark), which is

used to calculate a market credit risk premium.

Under normal conditions, this risk premium is positive, since

US Treasury bonds are considered to be risk-free and

derivative contracts are traded by counterparties that have

credit risk (see Addendum). However, concern has arisen in

international academic circles that after the financial crisis

this relationship or spread became negative, especially in

long-term contracts, which reveals excess demand for "low-

risk" assets, and more willingness to enter into swaps

compared to investing in treasuries. Some opinions considerthat this alteration of the spread is explained by: (i) the

contractual differences for each instrument, (ii) the higher

perception of risk due to the fiscal situation in the United

States that increases the sovereign credit risk, (iii) the failures

in the use of the LIBOR rate as a reference indicator, (iv) and

others. (See Figure 3).

It is, therefore, important to monitor the evolution and

relationship of derivative/hedge contracts with other assets.

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Figure 4. Participation of IBR, CPI, Fixed Rate and DTF

in the issue of corporate bonds in Colombia

Source: Bancolombia, BVC; IOSCO-EMC Annual Meeting, Santiago de Chile,

Nov. 2012.

Figure 5. Participation of the swap market in

Colombia, by each type of asset

Source: Bancolombia, ICAP, GFI, Tradition, Prebon; IOSCO-EMC Annual

Meeting, Santiago de Chile, Nov. 2012.

Additionally there has been particular interest in determining

the following: What is the correct structure for rates in the

swap market? And what are the determining factors for the

behavior of these types of instruments?

These questions are not only important for the financial

markets in developed countries. Emerging markets have been

able to cope with a turbulent world environment and,

therefore, they need to safeguard recent success from

potential risks. Accordingly, the relevance and relationship of

derivative interest rate markets with respect to local assets

must also be a matter of interest for the Colombian market.

Despite being a relatively new interest rate indicator, the

Banking Reference Indicator (BRI) - has gained ground in

terms of the share of the Colombian capital market since2008. For example, the issue of local corporate bonds indexed

to this indicator gained importance over the past few years. In

2009, only 4% of corporate bond issues were indexed to the

BRI. In 2011 this figure rose to 42% (see Figure 4). Meanwhile,

in the interest swap market the BRI also gained relevance

between the end of 2011 and 2012, to the detriment of the

DTF and Cross-Currency Swaps or Exchange Rate Swaps (see

Figure 5).

Over the past few years there has been a significant decline in

the regional swap curves. Within financial markets there has

been a drop in the swap rates in Brazil, Colombia, Chile,

Mexico, and Peruvian markets. A particular characteristic is

the correlation between these rates and an expansive

monetary policy cycle.

This section of the report seeks to identify the explanatory

factors, causality and transmission channels of swap rates to

their most liquid benchmarks (2, 5 and 10 years).

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Figure 6. Impulse - Response in the 2-year tenor for

CCS Colombia (measured in basis points - bp)








Given market and economic variables, the intention was to

identify how the more liquid benchmark in the Cross Currency

Swap (CCS) curve respond, where there is more historic data,

to a positive shock of 1 standard deviation (1 S.D) in a 12-

month period on various market and macroeconomic

variables.

The macroeconomic variables that showed the highest impact

on the CCS in the analysis were: (i) the product gap (the

difference between the observed GDP and its potential level),

(ii) the inflation gap (the difference between observed

inflation and the inflation expected by market analysts), (iii)

the National Central Government's (NCG) deficit, and (iv) total

debt (internal and external) as a percentage of GDP.

Among the market variables, the most liquid nodes inColombias Cross Currency Swap curve for and Latam were

taken into account as well as the IRS: Interest Rate Swap for

the United States. Based on the preceding analysis, it appears

that increases of one standard deviation in the interest rate

for 2-year US Treasuries and in the 10-year node for the IRS

curve in dollars (swap of the LIBOR rate for the fixed rate in

dollars) are associated with increases in the most liquid nodes

in Colombia CCS Curve. One aspect to consider is that in

Colombia's case the CCS curve is sensitive to the international

risk-free rates, especially in a context of ample liquidity.Although not included in the results, monetary policy does

not have the most impact, but it does generate "causality".

Due to the above, if the rate expectations change in the

medium-term, for example, if US interest rates increase due

to less risk aversion or to inflationary effects, the CCS in

Colombia would be expected to adjust upwardly. A possible

explanation of this behavior is that a large part of the investor

base in this market is made up of players in global markets

that would use this instrument as a hedging mechanism. (See

Figures 6, 7 and 8)

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Figure 9. Impulse -Response in the 2yr CCS Colombia

given changes in the CCS Latam (measured in bp)


Figure 10. Impulse -Response in the 5yr CCS Colombia

given changes in the CCS Latam (measured in bp)


Figure 11. Impulse -Response in the 10yr CCS

Colombia given changes in the CCS Latam (measured

in bp)


It was also found that the CCS curve in Colombia is very

sensitive to market risk indicators such as the EMBI+

Colombia:Emerging Markets Bond Index, which relates to thecountry risk premium, and the VIX.

This suggests that given increases in these risk variables,

market agents discount a downward bias in local rates, which

are associated with reductions in the monetary policy rate in

response to increases in global uncertainty that have a direct

effect on economic activity. This association could owe to the

novelty of these rate instruments that have mainly been in

use over the past four years, which also coincides with the

period of the highest international volatility, as was explained

at the beginning of this report. (See Figures 6, 7 and 8)

Another approach is to identify how the main CCS curve inLatam affects the evolution of the curve's nodes in Colombia.

A relevant aspect is that the Colombia curve maintains a

positive relationship with the most developed rate derivative

markets in the region, such as in Brazil, Mexico, and Chile.

This suggests that changes in the tone of monetary policy in

the region moving from a neutral position to a more

hawkish or dovish positionare effectively reflected by the

CCS in Colombia.

By contrast, the CCS nodes in Peru maintain a negative

relationship with the Colombian curve nodes. This may be due

to the fact that the Peruvian economy is semi-dollarized, and

its monetary policy is strongly oriented to attempting to

minimize exchange mismatches, which does not necessarily

coincide with the monetary policy cycle in Colombia. (See

Figures 9, 10 and 11)

In conclusion, we emphasize that given the more challenging

economic and financial environment, these types of volatility

hedge tools VIX and VXX, as well as those for interest

rates (interest rate and/or exchange rate swaps) are

progressively more relevant within risk and portfolio

managers.

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8/23

The development of the local interest rate hedge markets will

continue to gain relevance in coming years. This places their

understanding, accurate valuation methods, and analysis on

the frontier of development for the local and regional capital

markets in the coming years.

To analyze the fixed income market, it is very useful to include

the listed prices for swap contracts. In theory, in which

arbitrage opportunities are completely exhausted and market

friction is irrelevant, the information regarding the temporary

structure of interest rates is uniform among all instruments,

whether spot or derivatives. However, given the real worlds

complexities, the signs offered by swaps acquire particular

validity in the following respects:

1. The interest rate swaps spreads are highly influenced by

liquidity conditions in the financial market. In times of

ample liquidity, as is currently the case in the main

developed economies, there are significant reductions in

the swap spreads. This is due to the ease of obtaining

funds, the high appetite for risk and the search for higher

yields that characterize these situations. The broadening of

swap spreads may therefore be an indication of change in

the availability of resources in an economy.

2. The swap rates are also a good thermometer of the

perceived credit risk of the agents. While the sovereign

debt market in a nation operates under the premise of

nearly zero country risk, the swap spreads reflect the

perception of the average risk of intermediaries in that

market. This allows for the clear identification of concerns

that would otherwise go unnoticed. An example is the

current fear for the fiscal health of the United States in the

long-term (see page 3).


9/23

Figure 12. TES and CCS rates in the 2 year tenor


3. Thanks to the swaps it is possible to detect high financial

stress situations perceived by market agents. This is due

to the fact that in a debt security the buyer is exposed to

the payment of the principal by the issuer, while in

standard interest rate swaps this does not occur. A strong

preference for being exposed to one swap rate that leads

to a compression of spreads in that market, in turn may

suggest the possible occurrence of a credit event in the

spot market.

4. Given its flexibility and volume, the swaps market

facilitates the acquisition of exposure to certain assets in

a convenient manner, which overcomes the restrictions

that may occasionally arise in the spot market, both in

terms of the supply of securities and transaction costs.

This means that swap rates may capture agent

preferences early, before they are revealed in debt

markets. For example, Figure 12 shows that the 2-year

CCS in pesos has anticipated on numerous occasions

movement in the short portion of the Colombian

government debt curve over the past few years.

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New Market Dynamics:The divergent performance of fixed income

and equity markets over the past few years, coupled with the

better performance of the former, suggests that stocks at the global

level present more attractive entry levels.

A Different Situation in Colombia? The development at the local

level has presented certain similarities with respect to their

international peers, although local factors have prevailed in recentyears, especially with respect to fixed income securities. In

Colombia the perception is also that the equity market is more

attractive compared with the fixed income market, although

theoretically to a lesser degree than at the international level.

How much is risk worth? The Equity Risk Premium (ERP) measures

the additional return an investor would demand for investing in

risky assets, compared to investing in a risk-free asset. The implicit

ERP for Colombia is 6.89%, higher than the historic ERP of 5.4%, but

it is more reliable given the limitations of the second method.

Expensive or cheap? The local equity market is close to its fair

value, taking into account future corporate earnings and current

market risk. It was also found that stocks in Colombia are neither

undervalued nor overvalued with respect to sovereign bonds.

Mauricio Amador

Strategist for Portfolios and

Consumer Sector

[email protected]

(571) 353 6.600

http://investigaciones.bancolombia.

com

Bloomberg: BCLB and VBCL

January 30, 2013


11/23

Figure 1. 10-year US treasuries


Figure 2. 10-year sovereign bonds Germany,

Switzerland, Denmark and Finland


Figure 3. 2-year sovereign bonds Germany,

Switzerland, Denmark and Finland


During the global financial crisis in 2008, the various equity

markets suffered sharp losses simultaneously, while there

was a notable recovery in 2009. During this time the fixedincome and equity markets showed similar behavior in

response to the crisis. However, their evolution over the past

three years has been uneven, which has given rise to a

significant gap between bonds and stocks, suggesting that the

latter is more attractive.

The ultimate safe harbor asset is the US 10-year Treasury and

it has recorded strong increases since 2010, as demonstrated

by the more than 200 bp decline in its yield. The fiscal crisis in

Europe has had a negative impact on rates, since investors

have sought more secure assets. However, the behavior of

this asset has not been completely rational over the past few

years. Treasuries appreciated significantly in 2010 when there

were doubts as to the sustainability of the country's economic

recovery. The same reaction took place with respect to the

2011 debt ceiling problem and the subsequent loss of the

"AAA" rating granted by one of the major rating agencies.

Although under normal conditions these events would have

led various investors to liquidate their positions, the

Treasuries have had a positive reaction. A large part of this

behavior is due to the three monetary stimulus packages (QE)

implemented by the Fed since the end of 2008, and the

different monetary policy tools that have been applied to

drive economic growth. Current rates, which in previous

months reached their lowest levels in history, are therefore

artificially low.

A similar phenomenon is observed in Europe when analyzing

the performance of fixed income security markets in countries

considered to be safe harbors. In fact, the nominal rates for 2year bonds in countries such as Germany, Switzerland,

Norway, and Finland over the past few months have entered

negative territory for the first time in their history.

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Figure 4. Sovereign debt spread in peripheral

countries compared with Germany


Figure 5. Evolution of the MSCI Global index


Figure 6. Performance of stock indexes in the United

States, Europe and Japan


The picture is different in peripheral countries such as Greece,

Italy, Spain, Portugal, or Ireland. Their sovereign bonds

declined sharply in value in 2011 given the growing fears of

default and the possible breakup of the economic block.

However, in 2012 their performance reversed and they

exhibited significant increases in value due to the reduction of

their deficits and the implementation of strict austerity

policies.

The situation in equity markets was similar since several of

the uncertainties that affected fixed income securities also

had an impact on their behavior. However, their performance

was different. 2010 was a year in which the market recovery

continued, but at a slower rate, and the MCSI Global index

recorded increases of nearly 10%. The concerns mentioned

previously made 2011 more challenging for investors, and the

market erased nearly all the gains achieved in the preceding

year. A more encouraging picture arose in 2012, despite the

political uncertainty in the United States. Accordingly, the

gains accumulated since 2010 are practically the same as

those recorded the previous year.

There were, however, disparate results in the various stock

markets. Over the past three years, the S&P500 index has

appreciated by 28%, while the European market rose only

10%. There were also large differences between theirmembers. While the stock market in Germany rose by 28%,

the markets in Spain and Italy fell by nearly 30% and Greece

lost almost 60%. In Latin America the stock market indexes in

Mexico and Peru advanced by 36% and 46% respectively over

the past three years, while Brazil accumulated losses totaling

11%.

The divergent performance of fixed income and equity

markets over the past few years, coupled with superior

performance of the former, suggests that stocks at the globallevel present more attractive entry levels.

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13/23

Figure 7. Performance of stock indexes in China, Brazil

and Mexico


Figure 8. Evolution of the Coltes index

Source: Grupo Bancolombia, BVC.

Figure 9. TES yield rate performance July 2024


The behavior of local markets presented some similarities to

their international peers, given the high correlation that they

exhibit and the impact on Colombia of events such as thefiscal crisis in Europe, or the slowdown of the global economy.

However, local factors are those that have predominated in

the past few years, especially in the fixed income market.

Although TES yields also fell dramatically to nearly historic

lows, it cannot be said that they are artificially low. It is true

that a more expansive monetary policy with lower REPO rates

contributed to this performance. However, the better

economic outlook and lower inflation also gave rise to a

decline in the cost of debt in Colombia. There is also

increasingly less country risk, as reflected in the investment

grade rating granted to Colombia in 2011 by the main rating

agencies.

The local stock market also put in a good performance over

the past few years. The Colombian stock market ended 2010

with the Colcap index up by 33.4%, which made it one of the

markets with the best gains in the world, and number three

regionally, mainly due to the steep reduction in the perceived

country risk. As was the case internationally, 2011 was a

challenging year, although in Colombia the historic record of

new issues in the equity market had a significant effect.

Finally, last year's solid economic and corporate fundamentals

drove the stock market up by 16%.

Accordingly, in Colombia the perception is also that the equity

market is more attractive compared with the fixed income

market, although theoretically to a lesser degree than at the

international level.

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Figure 10. Evolution of the Colcap index


Figure 11. Forecast for the Colcap index 2013

Source: Bancolombia.

This situation is not expected to change much in the short-

term, given the expectations regarding the various assets.

While the long end of the local government debt curve

showed a significant decline, further declines in 2013, even if

at a more moderate pace, cannot be ruled out. This would

occur due to the possibility of a new rate cut by Central Bank,

a positive economic outlook for Colombia within a context of

low inflation pressures. Similar performance is expected for

sovereign bonds at the international level, since the economic

stimulus in developed countries would continue, coupled with

a possible economic recovery of the main economies around

the world.

However, the outlook for the fixed income securities market

in 2014 is less encouraging in Colombia, given the possiblestart of a tightening cycle by Central Bank, and influenced by

the international environment. In turn, the main catalyst for

this will be the exit strategy that could start to be

implemented by the U.S. Fed to drain liquidity from the

market.

The performance of the local stock market in the next few

years will be largely determined by the positive

macroeconomic outlook for Colombia, which would be

reflected in the solid operating and financial results obtained

by listed companies. This is why moderate increases in value

are anticipated for 2013, also supported by the relative

decline currently presented by the stock market. Similar

behavior is expected globally in the main stock markets,

although there are new challenges that investors will have to

face. Even though a tax agreement was reached in the United

States, the discussions regarding spending cuts and the raising

of the debt ceiling will continue to apply pressure and cause

uncertainty during the first few months of the year. The

concerns regarding the fiscal health of Europe continue buthave decreased as a result of the advances that were made in

2012.

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15/23

The economic outlook is more optimistic, since various

analysts expect a further acceleration in the economies of the

United States and China.

This would take place under a framework of an expansive

monetary policy, which may be more visible during the

second half of the year. Corporate earnings would also

recover in line with the economy, and would be factors that

would positively affect global equity markets this year.

The short-term outlooks for fixed income and equities

markets are therefore positive. This means that investors

have to decide which is the best choice for investing their

capital. Concerns such as the following arise: How much more

earnings can be expected from stocks given the current return

offered by sovereign debt with a lower basic risk? Is thehigher risk assumed in equities justified, given their

fundamental outlook? Comparatively speaking, which market

may be able to present a greater gain?

The Equity Risk Premium (ERP), or Risk premium of the Stock

Market, is a tool that will help to partially answer these

questions. It measures the additional yield that will be

demanded by an investor to invest in risky assets, compared

with investing in risk-free assets. When the ERP goes up, it

means that agents are asking for a higher price for risk.

There are several factors that may influence the ERP level.

One of the most important is investor risk aversion and during

periods of high uncertainty and higher risk aversion, the ERP

will tend to rise. Another important element is the economic

situation in the country and its respective stability. There are

also other factors such as market liquidity and corporate

governance.


16/23

Table 1. Historical ERP in Colombia

TES Equities

2008 12.5% -17.2%

2009 21.1% 66.4%

2010 8.8% 35.4%

2011 7.8% -12.1%2012 15.4% 20.0%

Average 13.1% 18.5%

ERP 5.4%Source: Bancolombia.

There are two important methods for estimating the ERP. The

first consists of analyzing historical returns from stocks

compared with risk free investments.

The difference over a prolonged period of time, and in annual

terms, will result in the historical ERP. Although this is one of

the most used methods, there are important differences in

the calculation that could give rise to different results. The

period of time chosen, the risk-free asset used, and the

method applied to average the returns will make the ERP

different.

In addition, Damodaran1argues that it is especially difficult to

implement this method in markets that have a short and

volatile history. Clear examples are emerging markets, which

have also undergone significant changes in the short-term,have limited liquidity and, in general, are made up of a few

companies with large proportions in the market.

Despite these difficulties, the historic ERP for Colombia was

estimated. The Coltes index was used, as calculated by the

Colombian Stock Exchange, which measures the general

progress of the domestic TES Class B government debt

securities segment in pesos, and the total returns (including

dividends) of the main stock market index (the Colcap). It

should be noted that there is very little history available since

the information only dates from 2008. However, using this

period of time the historic ERP was found to be 5.4%,

although there is high volatility over time.

There is a second method to calculate the ERP. It consists of

estimating it with a view to the future based on the current

market level and future flows for investors. One of the

advantages of this ERP is that it does not depend solely on

past information and therefore may be applied to relatively

new and volatile markets. One of the most used methods to

calculate the implicit ERP is the discounted dividends method.

1Aswath Damodaran, Equity Risk Premiums (ERP): Determinants,

Estimation and Implications. 2012.


17/23

Figure 12. Earnings per share vs. Colcap index


Figure 13. Colcap Earnings per share forecast


Under this method the equity value is equal to the present

value of the future dividends received from the investment.

In turn, the discount rate depends on the return demanded

by investors to invest in risky instruments. Finding the latter

value and comparing it against the risk-free rate determines

the ERP.

However, since only dividends are used, other aspects of

value for the investor may be missed. There is a body of

thought based on the theories of Modigliani and Miller2,

which argues that the dividends paid by a company are

irrelevant to its value. Over the past few years the notion

that dividends not paid to investors are reinvested in the

business has become more accepted, thereby generating

greater wealth for the stockholder due to the eventualgrowth of the company. Warren Buffet agrees with this

concept in his theory of Look through earnings3.

Taking all of the above together, it must be borne in mind that

not all companies distribute dividends to their investors. In

general, mature companies have sustained dividend policies,

although there are significant exceptions such as Berkshire

Hathaway, Google, Amazon or even Apple, which started to

pay out dividends recently. The newer companies prefer to

reinvest in their own businesses to achieve growth, thereby

providing a higher rate of return, an event that occurs

frequently in emerging markets.

To estimate Colombia's ERP this paper uses a model that

includes the earnings per share for companies listed on the

Colcap index. The main variables and assumptions used in the

exercise are as follows:

Earnings per share (EPS): projected on an individual basis or

taken from the valuation models for the companies under

coverage.

2F. Modigilani and M. Miller, "The Cost of Capital, Corporation Finance and

the Theory of Investment," American Economic Review, 1958.3Warren Buffet, An Owners Manual, Berkshire Hathaway, 1996.

10

35

60

85

110

135

700

950

1200

1450

1700

1950

Jan-08 Sep-08 Apr-09 Dec-09 Jul-10 Feb-11 Oct-11 May-12 Dec-12

Colcap

EPS (right axis)

10

35

60

85

110

135

160

185

210

235

Jan-08 May-10 Aug-12 Nov-14 Feb-17 Jun-19 Sep-21 Dec- -23


18/23

For other companies, both the economic growth of

the country and the inflation level were also taken

into account.

Risk-Free Rate: The exponential moving average of

the rate of return on Colombian TES sovereign bonds

maturing in July 2014, less the country risk

determined by the Colombian CDS (credit default

swap).

Perpetuity growth rate (g): Using the various

valuation models for the individual companies.

The model described above results in an implicit ERP of 6.89%

for Colombia. This is the percentage that an investor would

want in order to invest in the equity market, instead of

investing in a risk-free asset. This result is comparatively

higher than the nearly 6% rate calculated by Damodaran for

the United States, which seems to be coherent with the risk

associated with the characteristics of the country.

Furthermore, the 6.9% is also higher than the historic ERP of

5.4%, but it is more reliable given the limitations of this

method in emerging markets, as indicated previously.

It is important to note that the ERP is not a static variable over

time and it may change based on the market environment.

To analyze its sensitivity, we have used four different

scenarios, as follows:

1. If the Colcap had not recorded such a significant spike

in the final quarter of the year (+9%) and had been at

1,680 points.

ERP: 7.56%

2. If the Colcap had reached 2,000 points.

ERP: 6.28%

3. If the yield on the TES had continued to fall to 5%.

ERP: 7.60%


19/23

Table 3. Fair value model results

Current level Fair valuePotentialupside

Colcap 1,825 1,888 3.4%


4. If the yield on the TES had returned to its

mathematical average over the past two years (7.3%).

ERP: 5.30%

Under these scenarios, it is clear that a fall in the stock market

index or in the yield on sovereign bonds would give rise to a

higher risk premium for investments, which means that they

would pay a lower price for risky assets. Conversely, a rapid

increase in the stock market index or in the TES rates would

result in a lower ERP.

Although the implicit ERP indicates the premium that wouldbe required for risky assets, it does not provide a judgment of

the value of the stock market. It is, nevertheless, an important

component for estimating whether stocks are overvalued or

undervalued.

Two different approximation methods will be used in this

report. A model similar to that used for the ERP will first be

applied, since it takes into account the future gains in the

market calculated at present value.

The assumptions regarding earnings per share and the risk-

free rate are the same as those used to calculate the ERP, the

result of which also serves as an input for this model. Long-

term inflation for the Colombian economy (3%) and the

potential GDP (4.5%) is also used.

The final result of the model shows that the fair value of the

Colcap index today would be 1,888 points. This suggests that

the market is currently trading below its fair value, although it

would have moderate upside potential (+3.4%). This meansthat the local equity market is close to its fair value. Notably,

if this same exercise is applied to the end of 2013, without

any significant change in the main variables, the model shows

a higher potential upside (+14.3%).


20/23

Figure 14. Performance of future gains in the Colcap


These conclusions are consistent with the performance seen

over the past few years. It should also be noted that the

Colombian market has reflected better performance than its

international peers since 2010. Although the Colombian

economy presents solid fundamentals, as do the main listed

companies, the result suggests that a large portion of those

fundamentals are currently included in stock prices.

There is another widely used approximation method to value

the equity market. The Fed Model was created by the

economist Ed Yardeni and despite its name it is not approved

by the US Federal Reserve. Its main objective is to determine

whether or not stocks are undervalued or overvalued

compared with sovereign bonds.

The model calculation uses the sovereign bond yield and thereturn on future gains in the stock market index, calculated by

definition as the inverse of the price-earnings ratio. This

model compared both indicators such that if they have the

same value they are at their fair value, given the fact that the

underlying instruments are considered to be substitutes. If

the bond dividend is higher, it would mean that stocks are

overvalued and vice-versa. The reason is that bonds would be

offering a higher yield with lower associated risk.

However, there are limitations that must be taken into

account when using this method. Stocks may remain

undervalued or overvalued for a prolonged period of time and

therefore it does not indicate when the best time to change

strategy would be. The bond market also responds to specific

factors, which could cause a bias in the valuation of the

stocks.

The model currently indicates that stocks in Colombia are

neither undervalued nor overvalued with respect to sovereign

bonds. The performance of future gains in the Colcap index is

currently 5.3%, very close to its 5.2% historic average since

2009.3,5%

4,0%

4,5%

5,0%

5,5%

6,0%

6,5%

7,0%

Jun-09 Nov-09 Apr-10 Sep-10 F eb-11 Jul-11 Dec-11 May-12 Oct-12

Return on FutureEarnings

Average


21/23

Taking into account that the yield on the July 2024 TES is

currently 5.4%, the result again suggests that the equity

market is close to its fair value. If compared with the risk-

free rate used in the previous exercises (discounting the

Colombian CDS), there would be limited upside potential.

The outlook for the local markets would therefore continue to

be favorable. The solid economic and corporate fundamentals

will continue to be included in stock prices, offering

continuous increases in value. However, the various visible

signs indicate that there is limited room available, and

therefore over the coming months no solid upswing in either

bonds or stocks is expected. In this scenario diversification

among assets becomes more relevant, in order to obtain

better yields while mitigating volatility in portfolios.

There are several methods for calculating the ERP and the

market's fair value, which reflect different results depending

on the variables used and the windows of time applied.

However, these conclusions are signs of the behavior of the

assets over time but are not precise tools to determine the

exact moment at which to make investment rotations.


22/23


23/23

(571) 353 52 87| BogotColombia

Juan Pablo Espinosa

Head of Economics and [email protected]

Andrs Ortiz

International Manager of the Economic Research

[email protected]

Alexander Riveros

Economist specialized in Colombian Macroeconomics

[email protected]

Brian Lesmes

Economist specialized in Central Banks and Financial System

[email protected]

Lucas Toro

Strategist for Corporate Debt

[email protected]

Luca Duarte

Strategist for International Sovereign Debt and Forex

[email protected]

Sebastin Franco

Intern

[email protected]

Lina SnchezIntern

[email protected]

(571) 353 66 00 | BogotColombia

Juan Nicols Pardo

Head of Portfolio and Equity Analysis

[email protected]

Mauricio Amador

Strategist for Portfolios and Consumer Sector

[email protected]

Juan Diego Meja

Strategist for the Financial Sector

[email protected]

Diego Buitrago

Strategist for the Energy and Infrastructure Sector

[email protected]

Laura Manrique

Intern

[email protected]

Luisa Fernanda Arce

Intern

[email protected]

DISCLAIMER

This report was drawn up by Bancolombia S.A.s Economic Research and Strategy Department in conjunction with Fiduciaria Bancolombias Financial Analysis Valore

Bancolombias Portfolio and Equities Analysis Departments, both latter entities belonging to the Bancolombia Group . The data and information herein contained should not b

considered as any advisory service, recommendation or suggestion on the part of the Bancolombia Group with regard to any investment decision or any type of transaction o

business to be carried out and therefore any use of such information shall be the sole responsibility of the user. The figures, interest rates and other data herein contained are fo

informative purposes only and do not constitute any type of offer or firm demand for any transaction that may be performed in connection with such.

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