2019 CFA level 3 qbank r 16 17 capital market expectations equity market val answers

Study Session 8, Module 16.10, LOS 16.r Related Material SchweserNotes - Book 3 Question #4 of 99 The following table re ects economic data for Market Q: Expected growth in total factor

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Question #1 of 99

Which of the following is consistent with a at yield curve?

A) Monetary policy is expansive while scal policy is restrictive.

B) Monetary policy is restrictive while scal policy is expansive.

C) Monetary policy is restrictive and scal policy is restrictive.

Explanation

If monetary policy is restrictive while scal policy is expansive, the yield curve will be at

(Study Session 8, Module 16.5, LOS 16.i)

A) Country A has a looser monetary policy and a faster growing economy.

B) Country A has a tighter monetary policy and a slower growing economy.

C) Country A has a tighter monetary policy and a faster growing economy.

Explanation

Countries with a tighter monetary policy and stronger economic growth will see higher

currency values In fact, in the early 1980s, the U.S had high real and nominal interest rates

due to a tight monetary policy, robust economy, and an increasing budget de cit This

resulted in a higher value for the dollar

(Study Session 8, Module 16.7, LOS 16.l)

Related Material

SchweserNotes - Book 3

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

A) Slowdown.

B) Initial recovery.

C) Early expansion.

Explanation

U.S Treasury In ation Protected Securities (TIPS) are protected against increases in in ation

They would be needed the least when in ation is falling During the initial recovery phase of

the business cycle, in ation is falling

(Study Session 8, Module 16.10, LOS 16.r)

The following table re ects economic data for Market Q:

Expected growth in total factor productivity 1.0%

Expected growth in capital stock, α = 0.4 1.2%

Using the Cobb-Douglas production function and the data provided, the expected growth

(percentage change) in real economic output for Market Q is closest to:

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Which of the following is NOT a characteristic of economic indicators as used in economic

forecasting? Economic indicators:

A) are di cult to understand and interpret.

B) can be adapted for speci c purposes.

C) have an e ectiveness that has been veri ed by academic research.

Explanation

Economic indicators are actually easy to understand and interpret

(Study Session 8, Module 16.8, LOS 16.n)

The late expansion phase of the business cycle is characterized by high con dence and

employment, increases in in ation, rising bond yields, and rising stock prices Investor

nervousness increases risk during this period The central bank also limits the growth of the

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Of the following investment strategies, which one would bene t most from a bottom-up

forecasting approach in predicting equity returns?

A) Allocating invested funds across various markets.

B) Buying and selling individual securities to capture short-term pricing ine ciency.

C) A macro hedge fund manager allocating funds among currency markets.

Explanation

In a bottom-up forecasting approach, the analyst rst takes a microeconomic perspective by

focusing on the fundamentals of individual rms indicative of buying and selling individual

securities to capture short-term pricing ine ciency

In a top-down forecasting approach, the analyst utilizes macroeconomic factors (e.g., interest

rate expectations, expected growth in GDP) to estimate the performance of market-wide

indicators, such as the S&P 500 Successive steps include identifying sectors in the market

that will perform best given market expectations

(Study Session 8, Module 17.3, LOS 17.e)

B) The discount rate.

C) The neutral rate.

Explanation

The Taylor rule determines the target interest rate using the neutral rate, expected GDP

relative to its long-term trend, and expected in ation relative to its targeted amount

(Study Session 8, Module 16.5, LOS 16.h)

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

A) The inventory cycle is shorter than the business cycle.

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

spending

C) Business spending is less volatile than consumer spending.

Explanation

Business spending is more volatile than consumer spending Spending by businesses on

inventory and investments are quite volatile over the business cycle As a percentage of GDP,

consumer spending is much larger than business spending The inventory cycle typically lasts

two to four years whereas the business cycle has a typical duration of nine to eleven years

(Study Session 8, Module 16.4, LOS 16.g)

Current and sustainable long-term growth

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

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We are provided with a constant rate of growth, so we can use the constant growth dividend

discount model for equity valuation:

(Study Session 8, Module 17.2, LOS 17.c)

Which of the following is consistent with a likely weak economy in the future?

A) Monetary policy is expansive and scal policy is expansive.

B) Monetary policy is restrictive while scal policy is expansive.

C) Monetary policy is restrictive and scal policy is restrictive.

Explanation

When both scal and monetary policies are restrictive, the yield curve is downward sloping

(i.e., it is inverted as short-term rates are higher than long-term rates), and the economy is

likely to contract in the future

(Study Session 8, Module 16.5, LOS 16.i)

Which of the following is most representative of an exogenous economic shock?

A) Ongoing expansionary scal policy by the federal government leading to higher

in ation and interest rates

B) A hurricane hitting the Gulf of Mexico resulting in the shut-down of many oil wells

and re neries and to higher oil prices

C) Anticipated loose monetary policy by a country’s central bank leading to in ation

and to depreciation in the country’s currency

P0 D 1 r−g D 0 (1 + g) r−g 0.075−0.025 100(1.025) 102.50 0.05

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An exogenous shock is something that occurs outside the normal course of an economy,

such as a natural disaster or unanticipated government policy The shock is unanticipated

and is not part of a trend as would be characterized by ongoing monetary or scal policy

(Study Session 8, Module 16, LOS 16.k)

Which of the following statements regarding emerging market government debt is most

accurate? Emerging market government debt is usually denominated in:

A) a non-domestic currency which makes them less credit risky.

B) a non-domestic currency which makes them more credit risky.

C) the domestic currency which makes them more credit risky.

Explanation

The key di erence between developed country government bonds and emerging market

government bonds is that most emerging debt is denominated in a non-domestic currency

(e.g., dollars, euros, etc.) The emerging government must obtain a hard currency to pay back

the principal and interest The default risk for emerging market debt is thus much higher

(Study Session 8, Module 16.8, LOS 16.o)

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

A) The equilibrium value for both Tobin’s q and the equity q is 1.

B) Tobin’s q compares the current market value of a company to the replacement cost

of its assets

C) The equity q compares the aggregate market value of the rm’s equity to the

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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 re ected in the sum of the market values of

the rm'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 rm'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 aggregate market value of the rm's equity to the net worth at replacement

value, not market value That is the reason the statement is false The replacement value is

measured as replacement value of assets less market value of liabilities

(Study Session 8, Module 17.4, 17.5, 17.6, 17.7, LOS 17.f)

Which of the following is NOT indicative of low risk in an emerging market economy?

A) Foreign exchange reserves are twice that of the short-term debt.

B) A foreign debt level that is 75% of GDP.

C) A current account de cit that is 2% of GDP.

Explanation

Foreign debt levels greater than 50% of GDP indicate that the country may be overlevered

Debt levels greater than 200% of the current account receipts also indicate high risk Current

account de cits (roughly speaking, imports are greater than exports) greater than 4% of GDP

can be problematic because the de cit must be nanced through external borrowing High

risk is also indicated when foreign exchange reserves are less than the short-term debt that

must be paid o in one year

(Study Session 8, Module 16.7, LOS 16.m)

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If in ation rises, the yields for TIPS will:

A) rise and their price will fall.

B) fall and their price will rise.

C) rise and their price will rise.

Explanation

If in ation starts rising, the yields for U.S Treasury In ation Protected Securities (TIPS) will

actually fall and their prices will rise because the demand for them increases as investors

seek out their in ation protection

(Study Session 8, Module 16.8, LOS 16.p)

An equity market's forecasted EPS is 15.30 Assuming a required real return on equity of 8%, a

current dividend of 10, current supernormal growth of 9.5%, a long-term sustainable rate of

growth of 2.0%, and a 20-year period of linear growth decline, the estimated forward

price-earnings ratio (P0/E1) of the market is closest to:

A) 15.4.

B) 19.3.

C) 23.1.

Explanation

With the data provided, we use the H-model for equity valuation to solve for the intrinsic

value of the index:

= [( ) + ( − )]

P0 D 0 r−g L 1 + gL N

2 gS gL

= 0.08−0.02 10 [(1.02) + 20 2 (0.095 − 0.02)]

= 166.67 [1.02 + 0.75] = 295.01⇒ P 0 / E 1 = 295.01 15.30 / = 19.28

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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?

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

to make an informed decision

B) Since the S&P 500 is earning signi cantly more than the Treasuries this indicates

the S&P 500 equity market is overvalued

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

are undervalued and should increase in value

Explanation

The Fed model assumes that the expected operating earnings yield on the S&P 500 (i.e.,

expected aggregate operating earnings divided by the current index level) should be the

same as the yield on long-term U.S Treasuries:

If the S&P 500 earnings yield is higher than the treasury yield, the interpretation is that the

index value is too low relative to earnings Equities are undervalued and should increase in

A top-down forecast of earnings per share for an equity market index is best described as:

A) using macroeconomic factors to estimate the performance of market-wide

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In a top-down forecast, the analyst utilizes macroeconomic factors (e.g., interest rate

expectations, expected growth in GDP) to estimate the performance of market-wide

indicators, such as the S&P 500 Successive steps include identifying sectors in the market

that will perform best given market expectations The other answer choices refer to the

bottom-up method of forecasting

A) The economies are often heavily dependent on consumer durables.

B) Their undiversi ed nature makes them susceptible to volatile capital ows and

economic crises

C) Equity investors should focus on growth prospects and risk.

Explanation

Small economies are often heavily dependent on the sale of commodities and their

undiversi ed nature makes them susceptible to volatile capital ows and economic crises

Which of the following is NOT a characteristic of a good forecast using capital market

expectations? The forecasts:

A) are subjectively formed.

B) have a minimum amount of forecast error.

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High-quality forecasts are objectively formed They are also consistent, unbiased, well

supported, and have a minimum amount of forecast error

(Study Session 8, Module 16.1, LOS 16.a)

If population is expected to grow by 3%, labor force participation is expected to grow by 0.25%,

spending on new capital inputs is projected to grow at 2.75% and total factor productivity will

grow by 0.75% What is the long-term projected growth rate?

A) 5.75%.

B) 6.00%.

C) 6.75%.

Explanation

The sum of the components is 3% + 0.25% + 2.75% + 0.75% = 6.75%, so the economy is

projected to grow by this amount

(Study Session 8, Module 16.6, LOS 16.j)

A) can provide precise quantitative forecasts of economic conditions.

B) provides a straightforward method of creating a model.

C) is better at forecasting expansions than recessions.

Explanation

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Econometric analysis can actually be di cult and time intensive to create.

(Study Session 8, Module 16.8, LOS 16.n)

Which of the following statements about the Cobb Douglas production function is least

accurate? The Cobb-Douglas production function assumes the:

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

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

present

C) growth in economic output must be less than the growth in corporate earnings.

Explanation

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 = AKαLβ

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 di erent, but over the

long-term the assumption is reasonable The Cobb-Douglas production function also

assumes constant returns to scale Thought of as e ciency, constant returns to scale implies

that total 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

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Which of the following is the best interpretation of the 10-Year Moving Average Price/Earnings

Ratio (also referred to as the P/10-year MA(E))?

A) By comparing the 10 year moving average P/E ratio for a market to the current P/E

ratio we can determine whether or not the market is over or under priced

B) A 10 year moving average P/E ratio greater than the current P/E ratio for a market

indicates the market is currently undervalued

C) The numerator of the P/10-year MA(E) is the value of the S&P 500 price index, and

the denominator is the average of the previous ten years’ reported earnings

Explanation

The numerator of the P/10-year MA(E) is the value of the S&P 500 price index, and the

denominator is the average of the previous ten years' reported earnings Both are adjusted

for in ation using the consumer price index Similar to a trailing P/E ratio, the P/10-year

MA(E) compares the in ation adjusted price of the market at a point in time to the market's

average real earnings over the previous ten years The other answer choices are probable

ways of valuing the market by comparing an historical average P/E ratio to the current P/E

but the P/10-year MA(E) ratio is de ned di erently

Frank Bowden is formulating the expected returns, standard deviations, and correlations for

bonds and equities given global economic forecasts Tom Weatherford is examining the returns

to a U.S small-cap stock based on analyst's forecasted returns versus the capital asset pricing

model and the security market line Which of the following about Bowden and Weatherford is

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Bowden is performing beta research and Weatherford is performing alpha research Beta

research involves setting capital market expectations for broad asset classes It is referred to

beta research because it is related to systematic risk Alpha research is concerned with

earning excess returns through the use of speci c strategies within speci c asset groups

Which of the following statements most accurately describes the relationship between the

intrinsic value of an equity market index and the input variables in the H model? The intrinsic

value of an index is:

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

negatively related to the required return

B) negatively related to the growth rate but positively related to the length of the

period of decline and required return

C) 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 (P0) is positively related to: the

length of the period of decline in years (N), both the sustainable (gL) supernormal (gs) 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 P0, the

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

2 gS gL

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

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

from more credit worthy instruments to less credit worthy instruments

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

from less credit worthy instruments to more credit worthy instruments

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

from more credit worthy instruments to less 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 would shift from say nine-month cash instruments down to

three-month cash instruments If (s)he thought that the economy was going to improve so that less

creditworthy instruments would have less chance of default, (s)he would shift more assets

into lower rated cash instruments Longer maturity and less creditworthy instruments have

higher expected return, but also more risk

(Study Session 8, Module 16.8, LOS 16.o)

Bond prices increase during a recession as in ationary decreases and interest rates decline

causing bond prices to increase since they are inversely related to the change in interest

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Which of the following statements regarding global economies is most accurate?

A) Neither emerging nor developed country economies are perfectly integrated.

B) Both emerging and developed country economies are perfectly integrated.

C) Developed economies are perfectly integrated but not emerging countries.

Explanation

Emerging market economies are noted for the fact that they are segmented (i.e., not

integrated) Even among developed countries, economies are not perfectly integrated For

example, the Federal Reserve in the U.S and the European Central Bank will respond to local

e ects in their economies, thus creating di erences in U.S and European economic growth

(Study Session 8, Module 16.7, LOS 16.l)

Suppose a cash manager has an investment horizon of one-year She has the choice of

investing in either commercial paper with a maturity of six-months or commercial paper with a

maturity of one-year If she pursues the former, she will roll over her investment in six months

to another six-month instrument The current rates are 5% annually on the six-month

commercial paper 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 can utilize this strategy in

either Country A or Country B If Country A has a savings de cit 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?

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She should invest in the one-year commercial paper By locking in the higher rate of 5.5%

over the one-year, she will earn a higher return than she would have if she had invested in

two successive six-month commercial paper notes of 5.0% and 5.2% [=(1+.05/2)

(1+.052/2)-1=5.17%] The savings-investment imbalances approach to forecasting currency

values states that countries with savings de cits will have to have strong currency values to

attract foreign capital A strong currency bene ts the investor so she should invest in Country

The higher than targeted growth and higher than targeted in ation argue for a targeted

interest rate of 6% This rate hike is intended to slow down the economy and in ation

(Study Session 8, Module 16.5, LOS 16.h)

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A return index that tracks the NASDAQ stock market index can be subject to:

A) survivorship bias and hence downward biased returns.

B) survivorship bias and hence upward biased returns.

C) back ll bias and hence upward biased returns.

Explanation

Survivorship bias can result when a return series is based on a stock index It will be biased

upwards if the return calculation does not include rms that have been dropped from the

index due to delistings

(Study Session 8, Module 16.1, LOS 16.b)

The Yardeni model is best explained as:

A) a variation of the constant growth dividend discount model in which earnings are

used instead of dividends, the yield on A-rated corporate bonds is substituted for r

B) being able to value the market by applying the model as a ratio with a value greater

than 1 indicating the market is overvalued

C) a variation of the constant growth dividend discount model in which earnings are

used instead of dividends

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The Yardeni model for estimating the equilibrium earnings yield (i.e., the fair earnings yield)

is based on a variation of the constant growth dividend discount model (CGM), in which

investors value total earnings rather than dividends:

We can restate the CGM to show that the earnings yield must be the di erence between the

required return on equity and expected long-term growth This is logical, since we assume

the total return on equity, r, must be the sum of the earnings yield, E1 / P0, and growth (i.e.,

capital gains), g:

Yardeni incorporates risk into his model by using the yield on A-rated corporate bonds, YB, as

the required return on equity, r The di erence between the yields on A-rated corporates and

risk-free treasuries serves as a proxy, although most likely understated, for the equity risk

premium Also, instead of the long-term growth assumed in the CGM, Yardeni uses a 5-year

growth forecast, LTEG, for the S&P 500 The model becomes:

The Yardeni model can be applied as a ratio:

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Which of the following statements is least characteristic of the bottom-up method of

forecasting investment returns?

A) The analyst compares expected performance of various indices to general asset

classes

B) Assessing a rm’s management to determine its willingness and ability to adopt

technology to remain competitive in the market place

C) Cash ow analysis is used to determine a rm’s investment potential.

Explanation

The analyst comparing the expected performance of indices to general asset classes, such as

equities, bonds, and alternatives to identify which class of assets will be expected to

under-or out-perfunder-orm is considered part of a macro-analysis top-down method of forecasting

In a bottom-up forecast, the analyst rst takes a microeconomic perspective by focusing on

the fundamentals of individual rms The analyst starts the bottom-up analysis by looking at

an individual rm's product or service development relative to the rest of the industry The

analyst should assess the rm's management and its willingness and ability to adopt the

technology necessary to grow or even maintain its standing in the industry Given the

analyst's expectations for the rm, the analyst uses some form of cash ow analysis to

determine the rm's investment potential (i.e., expected return)

B) A high scal de cit.

C) A government committed to structural reform.

Explanation

If a government is supportive of structural reforms necessary for growth, then the

investment environment is more hospitable Growth rates less than 4% may indicate that the

economy is growing slower than the population, which can be problematic in these

underdeveloped countries

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Suppose the United States has higher in ation than Japan The United States is in the late

expansion phase of the business cycle and Japan is in the initial recovery phase Using only the

PPP relationship for forecasting currency values and using the relationship between asset class

returns and the business cycle, which asset should the manager invest in?

A) Japanese stocks.

B) Japanese bonds.

C) U.S bonds.

Explanation

The PPP relationship states that countries with high in ation will see their currency

depreciate, so the manager should invest in Japan Within Japan, the investor should invest in

stocks because stock prices have just started to rise and will continue to do so for some time

Bond yields will soon rise and their prices will fall as the economy expands

(Study Session 8, Module 16.10, LOS 16.r)

Which of the following statements best identi es and explains which bond is used as the

expected return for a bond segment?

A) A zero coupon bond, because of the reinvestment rate assumption.

B) A coupon bond, because of the reinvestment rate assumption.

C) A zero coupon bond, because of the maturity assumption.

Explanation

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The yield to maturity on a reference bond in a segment is used as the expected return The

drawback to this approach is that the yield to maturity assumes that intermediate cash ows

are reinvested at the yield to maturity, which may be implausible if the yield to maturity is

quite high A zero coupon bond has no intermediate cash ows so it is not susceptible to the

reinvestment rate assumption of the yield to maturity in a coupon bond A zero coupon

bond's yield to maturity would be preferable to that of a coupon bond

Which of the following describes a method of setting capital market expectations where a

consistent set of experts is asked for their opinion regarding the future?

A) A market-adjusted algorithmic method.

B) An algorithmic method.

C) A panel method.

Explanation

Capital market expectations can also be formed using surveys If the group polled is fairly

constant over time, this method is referred to as a panel method

(Study Session 8, Module 16.3, LOS 16.d)

A) Changes in spending on new capital inputs.

B) Changes in employment levels.

C) Changes in consumer spending.

Explanation

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Although consumer spending is the largest component of GDP, it is fairly stable over time To

forecast a country's long-term economic growth trend, the trend growth rate can be

decomposed into two main components: changes in employment levels and changes in

productivity The former component can be further broken down into population growth and

the rate of labor force participation The productivity component can be broken down into

spending on new capital inputs and total factor productivity growth

(Study Session 8, Module 16.6, LOS 16.j)

When using dividend discount models to evaluate the sensitivity of equity market value

estimates to changes in input variables, which input variable remains constant?

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

to decline in a constant linear fashion

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

C) The current dividend (D0) since it is not an estimate

Explanation

The current dividend is the only input variable that is not an estimate thus it is assumed to be

constant when evaluating the sensitivity of equity market value estimates to changes in input

variables when using the H-model and constant growth dividend discount model The other

input variables (the length of the growth decline period (N) in the H-model, the sustainable

and supernormal growth rates, and the required return) are all varied to see their impact on

the intrinsic value calculated using either model

(Study Session 8, Module 17.2, LOS 17.d)

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

% Growth in Total

Factor Productivity

% Growth

in Capital Stock

% Growth

in Labor Input

Output Elasticity of

Capital (α)

Output Elasticity of

Labor (1 − α)

If the next expected dividend is 150 and the required equity return is 8%, the intrinsic price

level of the equity index is closest to:

A) 2,564.00

B) 2,396.00

C) 2,620.00

Explanation

Using the Cobb-Douglas production function and the data provided, the long-term

sustainable growth rate in GDP is:

%ΔY = %ΔA + α(%ΔK) + (1 − α)(%ΔL) = 1.0 + 0.7(1.0) + 0.3(1.5) = 2.15%

Using the constant growth dividend discount model and the growth rate of 2.15%, the

intrinsic value is estimated to be:

Which one of the following represents possibly the most di cult task the government faces in

the event of an exogenous shock?

A) Rebuilding infrastructure after a natural disaster.

B) Being able to lower interest rates in a de ationary environment.

C) Preventing the shock from becoming a contagion and spreading to its own country.

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Banks are usually severely impacted by a nancial crisis shock In reaction the country's

central bank attempts to stabilize the banking system and the economy by injecting liquidity

into the system by maintaining or lowering interest rates It would be virtually impossible to

lower interest rates further in an already low in ation, low interest rate, or de ationary

environment Although rebuilding after a major natural disaster could be di cult it would still

be possible given enough resources A country can prevent or minimize the impact of a

contagion spreading to its own country due to a nancial shock by having sound scal and

monetary policies that will prevent the country from defaulting on its debt and prevent or

minimize the impact of nancial bubbles

(Study Session 8, Module 16, LOS 16.k)

Which of the following statistical tools adjusts historical estimates using a weighted average of

the historical value and an analyst-determined value?

A) Shrinkage estimator.

B) Time series analysis.

C) Multifactor model.

Explanation

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

where the weights and other estimates are de ned by the analyst Shrinkage estimators

reduce (shrink) the in uence of historical outliers through the weighting process This tool is

most useful when the data set is so small that historical values are not reliable estimates of

future parameters

Xavier Fellows works in the research department of Multinational Inc., a large investment bank

He is tasked with forecasting economic conditions to support the bank's money managers and

traders

Fellows takes his work seriously and is considered to be an excellent forecaster His economic

forecasts are updated monthly and sent to most of Multinational's analysts and money

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managers The analysts use Fellows' forecasts as the basis for their own research on speci c

securities or asset classes

However, Fellows is concerned that his forecasts are not accurate enough In an e ort to avoid

making mistakes, Fellows follows 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 clientswith di erent investment goals and constraints, and Fellows knows analysts will need the

di erent benchmarks for a variety of di erent types of investors

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

3 Assemble data on historical returns and valuations for all relevant asset classes,considering potential biases, adjusting the numbers to account for di erent calculationmethods, and ensure that data de nitions match those used by the company thatcollected the data

4 Interpret the data Fellows uses his years of experience to extrapolate that data intogrowth and valuation assumptions for each asset class This step is the most subjective

5 Distill assumptions into top-down forecasts, detailing the assumptions and methods forinterpreting historical data in the event that individual analysts want to use data tocreate their own industry-speci c forecasts

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

This month's forecast dwells heavily on in ation projections and their expected e ect on the

returns of di erent asset classes Fellows projects a decline in in ation 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 pleased with 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 in ation picture to Carol Huggins, a

colleague who works in the bank's management business Huggins consults on

money-management issues with large clients and is very interested in in ation projections

Lester Can eld, who manages money on a discretionary basis for high-net-worth individual

investors, is also interested in Fellows' forecast After reading the entire document, he decides

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to sell some of his clients' interest in a limited partnership that develops and manages real

estate, and invest that money in high-yield bonds Can eld's reasoning is threefold:

Can eld believes the partnership has excellent return potential, but he is the only onewho expects such robust results The bonds seem to be a safer investment, and Can elddoes not want to guess wrong

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

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

Before making the move, Can eld calls Fellows to get an opinion on his plan After hearing

Can eld's rationale, Fellows advises against the move into high yield bonds

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

A) identify where he obtained his data.

B) assure that the underlying data is accurate.

C) 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, but they would presumably fall

under steps three and ve of Fellows' process

Fellows' advice to Can eld suggests Can eld is least likely su ering from:

A) the recallability trap.

B) the prudence trap.

C) failing to use conditioning information.

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

and Can eld may not be considering information about changing economic conditions that

a ected 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 in ation or independent, that caused subpar real

estate returns The recallability trap has to do with allowing dramatic events to a ect

forecasts This issue is not relevant here

Andrews most likely requested bond yields because she wanted to:

A) develop a shrinkage estimate.

B) analyze stock-market valuations using the risk premium approach.

C) gauge potential xed-income investments.

Explanation

The risk premium approach uses bond yields and an equity risk premium to project market

returns Since Andrews is an equity trader, it is unlikely she is interested in xed-income

investments The question of shrinkage estimators is not relevant here

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

A) Failing to account for conditioning information.

B) Data measurement errors and biases.

C) It is di cult to use multiple regression analysis.

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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 uncertaintyDue to the problem of misinterpretation of correlations, it is often useful to run multiple

regressions An analyst may discover a stronger relationship between two variables that was

not evident using simple linear regression analysis

Due to the decline in in ation and the low bond yields, Fellows should conclude that the

economy is most likely in what stage of the business cycle?

A) Late expansion.

B) Slowdown.

C) Initial recovery.

Explanation

In general, in ation rises in the latter stages of an expansion and falls during a recession and

the initial recovery Bond yields peak during a slowdown and fall during a recession, however,

they bottom out during the initial recovery stage

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Tiêu đề	Capital Market Expectations Equity Market Valuation
Trường học	Kaplan
Chuyên ngành	Finance
Thể loại	Question Bank
Năm xuất bản	2019
Thành phố	New York

Định dạng
Số trang	61
Dung lượng	1,31 MB