Schweser QBank 2017 portfolio management and wealth planning 07 applications of economic analysis to portfolio management

Current and sustainable long-term growth Yield on 10-year government bond 6.0% Using the data in the table, the intrinsic price level of the equity market index is closest to: 2,929... E

Applications of Economic Analysis to Portfolio Management

Sharpe ratio of the global portfolio 0.29

Standard deviation of the global portfolio 8.00%

Degree of market integration for Market A 80%

Degree of market integration for Market B 65%

Standard deviation of Market A 18.00%

Standard deviation of Market B 27.00%

Correlation of Market A with global portfolio 0.86

Correlation of Market B with global portfolio 0.61

Estimated illiquidity premium for A 0.00%

Estimated illiquidity premium for B 2.50%

Next, we calculate the equity risk premium for both markets assuming full segmentation:

We then weight the integrated and segmented risk premiums by the degree of integration and segmentation in each market:

The expected return in each market figures in the risk-free rate:

Question #2 of 99 Question ID: 465370

Which of the following statements regarding spending and the business cycle is least accurate?

Business spending is less volatile than consumer spending

As a percentage of GDP, consumer spending is much larger than business spending

The inventory cycle is shorter than the business cycle

Explanation

Business spending is more volatile than consumer spending Spending by businesses on inventory and investments are quitevolatile over the business cycle As a percentage of GDP, consumer spending is much larger than business spending Theinventory cycle typically lasts two to four years whereas the business cycle has a typical duration of nine to eleven years

Which asset would perform the worst during deflationary periods?

Real estate financed with debt

Expected growth in the labor 1%

Expected growth in capital stock, α =

From the Cobb-Douglas production function we know that real economic output will change by: the same percentage change

as TFP, α times the percentage change in capital input, and (1 − α) times the change in labor input Consider a 1% increase ineach of the three variables individually while holding the others constant Using the Cobb-Douglas function below and an alpha

of 0.4, we can see that Δy = 1.0% for a 1% change in TFP (%ΔA), 0.4% for a 1% change in capital, and 0.6% for a 1% change

small country and its GDP should be forecast using a checklist approach

small country and its GDP should be forecast using an econometric approach

large country and its GDP should be forecast using an econometric approach

Explanation

Small countries with undiversified economies are more susceptible to global events Larger countries with diverse economiesare less affected by events in other countries An econometric approach can be very complex, involving several data items ofvarious time periods lags to predict the future They can be used to accurately model real world conditions

Calculate the short-term interest rate target given the following information

Question #7 of 99 Question ID: 465405

During which phase of the business cycle would TIPS be least useful to a portfolio manager?

Which of the following would indicate that a country is less affected by global events? The country is:

large and has a diversified economy

small and has a diversified economy

small and has an undiversified economy

Question #10 of 99 Question ID: 465366

Given an S&P 500 forward earnings yield of 7.2% and 10-year Treasury notes yielding 2.68%, which of the following

interpretations of this data using the Fed model is most accurate?

The spread between the S&P 500 earnings yield and the Treasury notes is too

great to make an informed decision

Since the S&P 500 is earning significantly more than the Treasuries this indicates the

S&P 500 equity market is overvalued

The S&P 500 earnings yield is higher than the Treasury yield indicating that equities

are undervalued and should increase in value

The expected return on the stock market is 1.8% + 3.4% + 5.0% - 0.6% + 0.2% = 9.8%.

Which of the following statements regarding Tobin's q and the equity q is least accurate?

The equity q compares the aggregate market value of the firm's equity to the

market value of the firm's net worth

The equilibrium value for both Tobin's q and the equity q is 1

Tobin's q compares the current market value of a company to the replacement cost of

its assets

Explanation

The equilibrium value of both Tobin's q and the equity q is assumed to be 1.0

Tobin's q compares the current market value of a company to the replacement cost of its assets The thinking is that the sum

of the replacement values of the individual assets should be the same as their aggregate market value, as reflected in the sum

of the market values of the firm's debt and equity The theoretical value of Tobin's q is 1.0 If the current Tobin's q is above(below) 1.0 the firm's stock is presumed to be overpriced (underpriced)

The equity q focuses directly on equity values and is interpreted the same way as Tobin's Q It compares the aggregatemarket value of the firm's equity to the net worth at replacement value, not market value That is the reason the statement isfalse The replacement value is measured as replacement value of assets less market value of liabilities

The following data pertains to an equity market index

Current and sustainable long-term growth

Yield on 10-year government bond 6.0%

Using the data in the table, the intrinsic price level of the equity market index is closest to:

2,929

2,050

2,000

0

However, Fellows is concerned that his forecasts are not accurate enough In an effort to avoid making mistakes, Fellowsfollows a detailed process to develop accurate and usable forecasts Fellows hopes that this process will help him avoid some

of the common problems of forecasts Here is his system:

1 Establish a benchmark for market expectations Multinational serves thousands of clients with different investment goalsand constraints, and Fellows knows analysts will need the different benchmarks for a variety of different types of investors

2 Look at the historical returns of a number of asset classes to act as a check on forecasts for each asset class

3 Assemble data on historical returns and valuations for all relevant asset classes, considering potential biases, adjusting thenumbers to account for different calculation methods, and ensure that data definitions match those used by the companythat collected the data

4 Interpret the data Fellows uses his years of experience to extrapolate that data into growth and valuation assumptions foreach asset class This step is the most subjective

5 Distill assumptions into top-down forecasts, detailing the assumptions and methods for interpreting historical data in theevent that individual analysts want to use data to create their own industry-specific forecasts

6 Monitor performance If Fellows' forecasts prove to be inaccurate, he works to improve his models

This month's forecast dwells heavily on inflation projections and their expected effect on the returns of different asset classes.Fellows projects a decline in inflation and predicts that bond yields have bottomed out

Stock analyst Karen Andrews calls Fellows after the report is released with some questions about his analysis She is pleasedwith the work, but a bit disappointed that he did not include information on current and estimated bond yields

Andrews asks Fellows to forward his analysis of the inflation picture to Carol Huggins, a colleague who works in the bank'smoney-management business Huggins consults on money-management issues with large clients and is very interested ininflation projections

Lester Canfield, who manages money on a discretionary basis for high-net-worth individual investors, is also interested inFellows' forecast After reading the entire document, he decides to sell some of his clients' interest in a limited partnership thatdevelops and manages real estate, and invest that money in high-yield bonds Canfield's reasoning is threefold:

Canfield believes the partnership has excellent return potential, but he is the only one who expects such robust results.The bonds seem to be a safer investment, and Canfield does not want to guess wrong

Historically, average high-yield bond returns are higher than the returns of real estate partnerships

During periods of falling inflation, real estate investments often lag the market

Before making the move, Canfield calls Fellows to get an opinion on his plan After hearing Canfield's rationale, Fellows

Question #15 of 99 Question ID: 485070

advises against the move into high yield bonds

Fellows skipped a step in his technique for producing forecasts He forgot to:

assure that the underlying data is accurate

identify where he obtained his data

identify a valuation model used in his analysis

Explanation

Fellows' plan mirrors the seven-step process for formulating capital-market expectations in every aspect except one,

identifying the valuation model used in the analysis Assuring the accuracy of data and identifying its source are important, butthey would presumably fall under steps three and five of Fellows' process (Study Session 7, LOS 16.a)

Fellows' advice to Canfield suggests Canfield is least likely suffering from:

the prudence trap

the recallability trap

failing to use conditioning information

Explanation

The relationship between historical returns and economic variables is not constant over time, and Canfield may not be

considering information about changing economic conditions that affected real-estate returns over short periods of time.Analysts fall into the prudence trap when they become overly conservative because they are afraid of being wrong The use of

ex post (after the fact) data to interpret ex ante (before the fact) actions is risky There may be other factors, whether

correlated with inflation or independent, that caused subpar real estate returns The recallability trap has to do with allowingdramatic events to affect forecasts This issue is not relevant here (Study Session 7, LOS 16.b)

Andrews most likely requested bond yields because she wanted to:

gauge potential fixed-income investments

develop a shrinkage estimate

analyze stock-market valuations using the risk premium approach

Explanation

The risk premium approach uses bond yields and an equity risk premium to project market returns Since Andrews is an equitytrader, it is unlikely she is interested in fixed-income investments The question of shrinkage estimators is not relevant here.(Study Session 7, LOS 16.c)

Which of the following is least likely a common problem encountered in forecasting?

Data measurement errors and biases.

It is difficult to use multiple regression analysis

Failing to account for conditioning information

Explanation

There are nine problems in producing forecasts:

1 limitations to using economic data

2 data measurement error and bias

3 limitations of historical estimates

4 the use of ex post risk and return measures

5 non-repeating data patterns

6 failing to account for conditioning information

7 misinterpretations of correlations

8 psychological traps

9 model and input uncertainty

Due to the problem of misinterpretation of correlations, it is often useful to run multiple regressions An analyst may discover astronger relationship between two variables that was not evident using simple linear regression analysis (Study Session 7,LOS 16.b)

Due to the decline in inflation and the low bond yields, Fellows should conclude that the economy is most likely in what stage

of the business cycle?

Which of the following is least accurate regarding inflation?

Low inflation affects the return on cash instruments

Declining inflation results in declining economic growth and asset prices

Highly levered firms are most affected by declining inflation rates

Explanation

Low inflation can be beneficial for equities if there are prospects for economic growth free of central bank interference.Declining inflation usually results in declining economic growth and asset prices The firms most affected are those that arehighly levered because they are most sensitive to changing interest rates Low inflation does NOT affect the return on cashinstruments (Study Session 7, LOS 16.g)

Question #21 of 99 Question ID: 465377

Which of the following is consistent with a steeply upwardly sloping yield curve?

Monetary policy is expansive while fiscal policy is restrictive

Monetary policy is restrictive and fiscal policy is restrictive

Monetary policy is expansive and fiscal policy is expansive

Explanation

When both fiscal and monetary policies are expansive, the yield curve is sharply, upwardly sloping (i.e., short-term rates arelower than long-term rates), and the economy is likely to expand in the future

Which of the following statements least likely represents a scenario from an exogenous shock?

Political unrest in the Middle East leading to an unexpected decrease in oil

production, increased oil prices, decreased consumer spending, increased

unemployment, and a slowed economy

OPEC not being able to agree on production levels leading to increased uncertainty in

global markets and increased oil prices

A country defaults on its debt payments, thereby causing the country's currency to

lose value and forcing the central bank to take measures to stabilize the banking

system and the economy

Explanation

The OPEC meeting and probable outcomes could be anticipated and already factored into current oil prices leading to theleast severe outcome of the answer choices Exogenous shocks usually lead to economic slowdowns, as in the case of an oilshock leading to higher prices, inflation, reduced consumer spending, increased unemployment, and a slowing economy Areduction in oil prices could be caused by a weak global economy with weak demand for oil or an oversupply of oil in the globalmarket This would reduce the price of oil and boost the economy, potentially overheating it in which causes high inflation andincreased interest rates that ultimately slow the economy down In a financial crisis the result is usually characterized by banksbecoming vulnerable and requiring action by the central bank to stabilize the banking system and economy by increasingliquidity and lowering interest rates

Which of the following statements about the Cobb Douglas production function is least accurate? The Cobb-Douglas

production function assumes the:

growth in total factor productivity (TFP) is zero when constant returns to scale

are present

output elasticities of capital and labor, α and β, sum to 1.0

The Cobb-Douglas production function (CD) uses the country's labor input and capital stock to estimate the total real

economic output The general form of the function is:

Y = AK L

Y = total real economic output

A = total factor productivity (TFP)

K = capital stock

L = labor input

α = output elasticity of K (0 < α < 1)

β = output elasticity of L (α + β = 1)

An assumption of the Cobb-Douglas production function is that economic growth and growth in corporate earnings are equal

In the short-term the two can be quite different, but over the long-term the assumption is reasonable The Cobb-Douglasproduction function also assumes constant returns to scale Thought of as efficiency, constant returns to scale implies thattotal factor productivity (TFP) remains constant (ΔTFP is zero) α and β are the output elasticities of capital and labor,

respectively The model assumes 0 < α < 1.0 and β = (1 - α) so that the sum of α and β is 1.0

Which of the following is least likely to be a bias in the top-down analysis model?

Models may be incorrectly specified using the wrong variables

Individual managers tend to be more optimistic than is warranted by the model

Econometric models may be slow in capturing changes in individual factors

Explanation

Individual managers being overly optimistic is a bias in the bottom-up approach Individual managers tend to be overly

optimistic about their firm's future thus aggregating individual manager expectations can lead to significantly over estimatingindustry expectations Biases found in the top-down approach can occur when models are sometimes slow in capturingstructural changes to the individual factors used in the model since historical data is used Also, the models may be incorrectlyspecified since the variables used in the past may no longer be appropriate

A Tobin's q value for an equity market of greater than 1 can be interpreted as the:

market is over-valued and will revert back to a value of 1

market is over or under-valued depending upon the equilibrium value

replacement cost of assets is over stated

α β

Question #26 of 99 Question ID: 465415

When using dividend discount models to evaluate the sensitivity of equity market value estimates to changes in input variables,which input variable remains constant?

The number of years (N) to reach the sustainable growth rate because it is

assumed to decline in a constant linear fashion

The current dividend (D ) since it is not an estimate

The sustainable growth rate since it is assumed to remain at a constant stable rate

Which of the following statistical tools adjusts historical estimates using a weighted average of the historical value and ananalyst-determined value?

Shrinkage estimator

Multifactor model

Time series analysis

Explanation

Shrinkage estimators are weighted averages of historical data and some other estimate, where the weights and other

estimates are defined by the analyst Shrinkage estimators reduce (shrink) the influence of historical outliers through theweighting process This tool is most useful when the data set is so small that historical values are not reliable estimates offuture parameters

Which of the following describes a method of setting capital market expectations where a consistent set of experts is asked for

0

positively related to the growth rate and length of the period of decline but

negatively related to the required return

negatively related to the growth rate but positively related to the length of the period of

decline and required return

positively related to the growth rate and required return but negatively related to the

length of the period of decline

Explanation

In the H-model shown below the intrinsic value of a market (P ) is positively related to: the length of the period of decline inyears (N), both the sustainable (g ) supernormal (g ) growth rates, and negatively related to the required return on equity (r)

We can see that as the required return (r) increases the denominator of the equation increases causing P , the intrinsic value,

to decrease resulting in a negative relationship between r and the intrinsic value P

Suppose the U.S has a persistent current account deficit Which of the following approaches to forecasting currencies bestexplains why the U.S dollar will be strong during this time period?

The relative economic strength approach

The savings-investment imbalances approach

The capital flows approach

Explanation

The savings-investment imbalances approach begins by stating that a savings deficit exists when investment is greater thandomestic savings To compensate for a savings deficit, a country's currency must increase in value and stay strong to attractand keep foreign capital At the same time the country will have a current account deficit where exports are less than imports.Although a current account deficit would normally indicate that the currency would weaken, the currency must stay strong to

0

0 0

Question #31 of 99 Question ID: 465392

attract foreign capital

Which of the following is NOT a characteristic of economic indicators as used in economic forecasting? Economic indicators:

are difficult to understand and interpret

can be adapted for specific purposes

have an effectiveness that has been verified by academic research

Explanation

Economic indicators are actually easy to understand and interpret

Which of the following regarding the formulation of capital market expectations is least accurate? An analyst should:

consider the investor's tax status, allowable asset classes, and time horizon

investigate assets' historical performance and their determinants

vary their assumptions when interpreting data and drawing conclusions

Only the direction of a change in interest rates is important

Both the direction of a change in interest rates and the level of interest rates are

important

Neither the direction of a change in interest rates nor the level of interest rates are

important

Explanation

Both the direction of a change in interest rates and the level of interest rates are important If, for example, rates are increased

to say 4% to combat inflation but this is still low compared to the neutral rate of 6% in a country, then this rate may still be lowenough to allow growth and inflation to continue

Question #34 of 99 Question ID: 465329

Which of the following is NOT a characteristic of a good forecast using capital market expectations? The forecasts:

are subjectively formed

have a minimum amount of forecast error

are consistent with the forecasts used for other assets

Explanation

High-quality forecasts are objectively formed They are also consistent, unbiased, well supported, and have a minimumamount of forecast error

If a cash manager thought the economy was going to have a robust recovery, (s)he would:

shift from shorter-term cash instruments to longer-term cash instruments and

from more credit worthy instruments to less credit worthy instruments

shift from longer-term cash instruments to shorter-term cash instruments and from

more credit worthy instruments to less credit worthy instruments

shift from longer-term cash instruments to shorter-term cash instruments and from

less credit worthy instruments to more credit worthy instruments

Explanation

Interest rates will increase during a robust expansion If a manager thought that interest rates were set to rise, (s)he wouldshift from say nine-month cash instruments down to three-month cash instruments If (s)he thought that the economy wasgoing to improve so that less creditworthy instruments would have less chance of default, (s)he would shift more assets intolower rated cash instruments Longer maturity and less creditworthy instruments have higher expected return, but also morerisk

Bill Litner, CFA and Susan Cabell, CFA are composing an economic and financial newsletter for the employees of TerrificTires, Inc (TTI) In it, Litner and Cabell will publish their capital market expectations The purpose of the newsletter is to helpTTI's employees make decisions in the management of their defined contribution pension plans

Litner and Cabell have subscribed to several sources of data to compose the forecasts that they intend to include in thenewsletter One data set consists of macroeconomic variables such as unemployment, interest rates, and output for varioussectors of the economy and the entire economy (GDP) Litner and Cabell compute the correlations of the macroeconomic datawith the returns of a select group of stocks They use 10 years of weekly data to compute the correlations After finding theeconomic variables that have the highest correlations with the stocks, they compose a model using those variables to predictthe returns of the stocks

Litner and Cabell also perform a factor analysis of stocks FGI and VCC Using a world index "S" and a world bond index "B" in

a two-factor model, they compute the following estimated equations for the returns of FGI and VCC respectively:

R = 1.4 × F − 0.2 × F + ε

Question #36 of 99 Question ID: 485084

Inflation is another variable that Litner and Cabell consider for their models They discuss the relationship between inflationand asset returns Cabell suggests that inflation can be used with GDP growth for predicting the Fed's next move on interestrates They look at their macroeconomic data to see how the current GDP growth compares to the trend GDP growth and thecurrent inflation compares to the Fed's announced inflation target They find that the current GDP growth is higher than thetrend GDP growth Inflation is lower than the announced target from the central bank Litner and Cabell employ the TaylorRule for predicting a change, if any, in the central bank's target for the short-term interest rate In considering how to addressinterest rates in their newsletter, Litner and Cabell also look at the shape of the yield curve, which is currently flat Litner andCabell discuss the conditions that could give a flat yield curve Litner says that such a curve is indicative of restrictive monetarypolicy Cabell says that a flat yield curve is indicative of expansionary fiscal policy

Litner and Cabell discuss the use of economic indicators that are available for governments and international organizations,and they agree that the availability of the indicators is one of the advantages of using such indicators Litner says anotheradvantage of such indicators is that economic variables and asset returns tend to have fairly stable relationships with theindicators that are fairly consistent over time Cabell adds that another advantage is that the economic indicators can bereadily adapted for specific purposes

Having assessed their available resources and strategy, Litner and Cabell begin composing their newsletter for TTI

employees

In composing their model using the macroeconomic data, the approach of Litner and Cabell:

is justified based upon the length of the data set but not by its using historical

correlations

may have problems because they are using data from too early a time only

may have problems because they are using data from too early a time and they are

assuming correlation is causation

Explanation

There is likely to be a regime change over a 10-year period, and it is not recommended that estimates for composing

expectations be based upon data going back such a long period Also, building a model based only on historical correlations isnot recommended because correlation is not causation (Study Session 7, LOS 16.b)

Using the results of the estimated factor models, the forecasted covariance of FGI and VCC would be closest to:

0.0445

Cov(i,j) = (1.4 × 0.8 × 0.04) − (0.2 × 0.1 × 0.007) + [(1.4 × 0.1) + (−0.2 × 0.8)](0.01) = 0.04446 (Study Session 7, LOS 16.c)

With respect to their comments concerning the relative volatility and size of business spending with respect to consumerspending Litner:

is incorrect and Cabell is correct

is correct and Cabell is incorrect

and Cabell are both incorrect

Explanation

Litner is correct in that business spending is more volatile, but consumer spending is many times larger than business

spending; therefore, Cabell is incorrect (Study Session 7, LOS 16.e)

With respect to how the central bank will change its target for the short-term interest rate, using the given information

concerning GDP and inflation and the Taylor rule, Litner and Cabell:

cannot predict how the target might change

would forecast an increase in the target

would forecast a decrease in the target

Explanation

According to the Taylor rule, GDP growth being higher than the trend GDP growth would lead the central bank to increasingthe target However, inflation is lower than its target, which would mean the central bank would tend to lower the target for theshort-term interest rate Without additional information, it is not clear how the central bank will change the rate if at all (StudySession 6, LOS 17.h)

With respect to what the current shape of the yield curve indicates:

both Litner and Cabell are incorrect

both Litner and Cabell are correct

Litner is correct and Cabell is incorrect

Question #41 of 99 Question ID: 465358

In their discussion of the advantages of using economic indicators:

Litner is incorrect and Cabell is correct

both Litner and Cabell are correct

Litner is correct and Cabell is incorrect

Explanation

The relationships do change over time, but the indicators can be adapted to various uses (Study Session 6, LOS 17.n)

Which inflation rate would allow for the greatest consistent long term growth of equity value?

5%

8%

2%

Explanation

Low inflation can be a positive for equities given that there are prospects for economic growth free of central bank

interference Inflation rates above three percent can be negative though because it increases the likelihood that the centralbank will restrict economic growth Declining inflation or deflation is also problematic because this usually results in decliningeconomic growth and asset prices The firms most affected are those that are highly levered They would face declining profitsyet would still be obligated to pay back the same amount in interest and principal

An analyst has gathered the following data for a developed market index:

% Growth

in LaborInput

OutputElasticity ofCapital (α)

OutputElasticity ofLabor (1 −α)

Question #44 of 99 Question ID: 465380

Using the constant growth dividend discount model and the growth rate of 2.15%, the intrinsic value is estimated to be:

Which of the following is NOT a substantial component of the change in the long-term growth rate in an economy?

Changes in spending on new capital inputs

Changes in consumer spending

Changes in employment levels

Explanation

Although consumer spending is the largest component of GDP, it is fairly stable over time To forecast a country's long-termeconomic growth trend, the trend growth rate can be decomposed into two main components: changes in employment levelsand changes in productivity The former component can be further broken down into population growth and the rate of laborforce participation The productivity component can be broken down into spending on new capital inputs and total factorproductivity growth

Suppose a cash manager has an investment horizon of one-year She has the choice of investing in either commercial paperwith a maturity of six-months or commercial paper with a maturity of one-year If she pursues the former, she will roll over herinvestment in six months to another six-month instrument The current rates are 5% annually on the six-month commercialpaper and 5.5% for the one-year maturity commercial paper If in six months, the yield for six-month commercial paper is 5.2%annually, should she invest in the two six-month instruments or the one-year commercial paper? Also assume that she canutilize this strategy in either Country A or Country B If Country A has a savings deficit and Country B has a savings surplus,which country should she invest in if she is using a savings-investment imbalances approach to forecast currency values?