CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 05 economics answers

Part B  Monetary policy most directly impacts short-term rates and increased money supply drives down those rates.. Those rates are higher in anticipation of economic recovery and an e

ECONOMICS ANSWERS

Question 1

Part A

The tools are monetary and fiscal policy Both are expansionary

 Monetary policy: The money supply is being increased at an above average rate, primarily driving down short term rates, to stimulate the economy

 Fiscal policy is expansive with the deficit (government spending – taxes) being increased to stimulate the economy

Candidate discussion: 1 point each for identifying the two tools 1 point each for explaining

what kinds of actions are consistent with expansionary policy for each

Part B

 Monetary policy most directly impacts short-term rates and increased money supply drives down those rates

 Long-term bonds are longer term investments reflecting the longer term outlook Those rates are higher in anticipation of economic recovery and an eventual rise in short-term rates and inflation as the expansive fiscal policy takes effect

Candidate discussion: 1 point each for why expansive monetary policy drives down short rates

while expansive fiscal drives up long-term rates

Part C

Recession; stocks move in anticipation of economic activity and generally begin to rally later in the recession In contrast, bond yields would bottom out and begin to rise leading to declining bond prices and poor returns

Candidate discussion: 1 point for recession and 1 point each for a correct discussion of

expected stock and bond performance

Note that late upswing is not particularly good for either and the slowdown would favor bonds

Question 2

Part A

Fed model: S&P earnings yield = 81/1221 = 6.6%

6.6

2.2

3  >1.0, indicates the earnings yield is too high because the price is too low and the market is undervalued

Yardini model:

0.0487 – 0.1(0.045) = 4.42% = fair earnings yield

Actual earnings yield of 6.6% is higher indicating market price is too low and the market is undervalued

Overall conclusion: disagree, both models show undervaluation

Candidate discussion: 1 point each, for disagreeing that each model indicates overvaluation

2 points for each set of calculations Note that if you do not show your calculations these points

are not earned If you set up the calculation correctly but then make a mistake, 1 point It is not required to write out the formula and it takes time to do so If you write it out and then make

a math mistake it may generate some partial credit

Fed model = S P earnings yield

Treasury yield

&

Yardini model predicts what the market should be yielding:

YB – d(LTEG) = E1 / P0

Part B

Repurchase is a complement to dividend payments; both provide cash flow to shareholders An increase in repurchase would increase expected stock return

Candidate discussion: 2 points for relating repurchase to dividends or increased cash flow to shareholders and 1 point for increased return

Showing the formula and explaining it is a decline in shares so - - ∆S = + repurchase yield is acceptable, but a lot more work

1 i

0

ˆ

 

A discussion that increased repurchase would lower dividend yield, or g, and therefore have no

effect will earn no credit GK is an aggregate market model and not a corporate finance

discussion of a single stock The presumption and consistent with observed behavior is the increased repurchase is in effect using idle cash that was producing no economic benefit and increases return

Question 3

A 3.10 + 0.20 + 0.30 + 0.10 + 0.08 = 3.78%

Sample Scoring Key:

One point for 3.78%, and two points for showing the relevant build-up components

Candidate discussion: Based on the case facts and question asked, inflation and the BBB

premium are not relevant because the starting point provided is the 1-year nominal rate

Nominal already includes an inflation component, and the bond evaluated is A, not BBB rated The tax premium is relevant and would reflect any differential between government and

corporate bond taxation The tax rules creating the differential are not given and not needed Knowing what to do with a risk premium when it is given is the issue

B Horizon analysis: Summer expects increasing interest rates and reinvestment rates Horizon

analysis can incorporate this

(Alternate explanation is that given the expected increase in interest rates, starting with the current 1-year rate for the build-up model will be inappropriate to model returns over a longer period.)

Sample Scoring Key:

One point for horizon analysis and two for the explanation Note that horizon analysis is another term for total return analysis (the math is covered in fixed income) and allows Summer to

explicitly incorporate his forecasts into projected total return

C

i

 CE does well as interest rates increase

 RE does well as real property values and rental income increase with inflation

ii

 B does well as the coupons and principal are nominally fixed but increase in purchasing power

Sample Scoring Key:

For i: one point each for a correct discussion of CE and RE For ii: two points for a correct discussion of B

Candidate discussion: It may be tempting to argue CE will do well in deflation CE is better

than stock or RE, which are likely to decline in nominal value, but CE is likely to earn a near-zero interest rate In contrast, B will continue to earn the higher coupon rates locked in before deflation started

D Estan is higher risk

 Monetary policy is less responsible than Mstan where the Taylor rule approach balances real growth with control of inflation

 Foreign currency reserves to service ST foreign debt are lower at only 8 months (1 / 150%)

 Estan is over-leveraged with foreign debt exceeding 50% of GDP

 The capital flows approach indicates currency outflow from Estan and currency

depreciation

 Nominal per capita growth rates are equal at 2%, but the central bank analysis indicates greater inflation risk and the likelihood of insufficient real per capita growth to maintain political stability

Sample Scoring Key:

Two points for Estan and one point each for three reasons

Candidate discussion: The only point indicating higher risk for Mstan is a less stable court

system The higher nominal growth for Estan does not indicate lower risk because it is offset by higher population growth and some indication of higher inflation Thus, real per capita growth in Estan is likely low, and this can lead to political instability