S6

Question 1

Steps in formulation of capital market expectations

Answer 1

DETERMINE the specific capital market EXPECTATIONS NEEDED according to the investor’s tax status, allowable asset classes, and time horizon.

INVESTIGATE assets’ HISTORICAL PERFORMANCE to determine the drivers.

IDENTIFY the VALUATION MODEL used and its requirements.

COLLECT the BEST DATA possible.

Use experience and judgment to INTERPRET CURRENT MARKET CONDITIONS and decide what values to assign to the required inputs.

FORMULATE CAPITAL MARKET EXPECTATIONS.

MONITOR performance and use it to REFINE the process.

Question 2

Factors in evaluation of data

Answer 2

Calculation methodologies. 
Data collection techniques. 
Data definitions. 
Error rates. 
Investability and correction for free float. 
Turnover in index components. 
Potential biases.

Question 3

Nine problems encountered in producing forecasts

Answer 3

EE LL MM NN P

(2) Error and bias in data measurement,
(4) Ex post risk and return measures being used,
(1) Limitations to using economic data,
(3) Limitations of historical estimates,
(7) Misinterpretation of correlations,
(9) Model and input uncertainty.
(5) Non-repeating data patterns,
(6) Not accounting for conditioning information,
(8) psychological traps, and

Question 4

data measurement errors and biases

Answer 4

transcription errors (recording)
survivorship bias
appraisal (smoothed) data

Question 5

Benefits from using long term data

Answer 5

. It may be statistically required.
. provides more precise statistical estimates
. less sensitive to the starting and ending points selected for the time period.

Question 6

Problems from using long term data

Answer 6

. Regime changes
. relevant time period is too short to be statistically significant
. more frequent data points are often more likely to have missing or outdated values (asynchronism) and can result in lower, distorted correlation calculations.

Question 7

Gordon growth model or constant growth mode

Answer 7

P0 (current) = D1 (next) /(R-g)

Question 8

Grinol Kroner model

Answer 8

Ri = exp ( income return) + exp (NOMINAL earnings growth ) + exp ( repricing return)

= ( D1/P0 - stock count growth) + (inflation + growth) + (p/e extension)

Question 9

Bond returns - risk premium approach

Answer 9

R = real risk-free rate + .......... In de li ma ta
\+ inflation risk premium 
\+ default risk premium 
\+ liquidity risk premium 
\+ maturity risk premium 
\+ tax premium

Question 10

CAPM model - return =

Answer 10

R=Rfr + asset beta x (market R - Rfr)

Question 11

Risk premium bonds & stocks =

Answer 11

Standard deviation x correlation x Sharpe

Question 12

ERP - equity risk premium

Answer 12

ERP =
= Standard deviation
x Correlation with global market (1 if fully segmented)
x Sharpe ratio
+ Illiquidity premium for developing countries

Question 13

ERP including segmentation / integration =

Answer 13

Degree of segmentation x ERP segmentation +

+ Degree of integration x ERP integration +

Question 14

Beta =

Answer 14

Correlation A with market x Standdev asset A / Standdev market

Question 15

The longer-term business cycle - length and phases

Answer 15

9 to 11 years

the initial recovery, 
early upswing, 
late upswing, 
slowdown, 
recession.

Question 16

Initial Recovery • • •

Answer 16

Few months.
Rising stocks (esp risk assets), confidence.
Falling inflation, short term interest
Government stimulation: low rates and/or budget deficits.
Large output gap
Bond yields are bottoming out.

Question 17

Early Upswing • • • • • • • •

Answer 17

1+ years
Increasing growth with low inflation, confidence, inventories, stocks, short term interest, bond yields
Output gap is narrowing.

Question 18

Late Upswing • • • • • • •

Answer 18

Confidence and employment are high.
Output gap eliminated and economy at risk of overheating.
Central bank limits the growth of the money supply.
Rising inflation, short-term interest rates, bond yields, stock (increased risk and volatility)

Question 19

Slowdown

Answer 19

Few months - 1yr or longer.
Inflation is still rising.
Falling inventory levels, stocks, confidence.
Peaking Short-term interest rates and Bond yields.
Yield curve may invert.

Question 20

Recession

Answer 20

Duration of 6mo-1yr.
Large declines in inventory.
Declining confidence, profits, short-term interest rates, bond yields, rising bond prices
Increase in unemployment and bankruptcies.
Inflation tops out.
Stock prices increase during the latter stages anticipating the end of the recession.

Question 21

Taylor rule

Answer 21

Rtarget = Rneutral + 0.5(GDPexpected-GDPtrend + InflationExpected-InflationTrend)

Question 22

If Monetary and Fiscal are stimulative, the yield curve is

Answer 22

steep and the economy is likely to grow.

Question 23

If monetary and fical are restrictive, the yield curve is

Answer 23

inverted and the economy is likely to contract.

Question 24

If monetary is restrictive and fiscal is stimulative, the yield curve is

Answer 24

flat and the economy is unclear.

Question 25

If monetary is stimulative and fiscal is restrictive, the yield curve is

Answer 25

moderately steep and the economy is unclear.

Question 26

country's long-term economic growth trend - 2 drivers

Answer 26

(1) changes in employment levels ... population growth ... rate of labor force participation (2) changes in productivity. ... Spending on new capital inputs ... total factor productivity growth.

Question 27

Investing in emerging markets, key questions

Answer 27

RESPONSIBLE fiscal and monetary POLICIES? .. Deficit to GDP ratio under 4%+ .. Debt levels under 70-80% of GDP EXPECTED GROWTH rate of at least 4%? STABLE CURRENCY values and CURRENT ACCOUNT deficits of less than 4% of GDP? FOREIGN DEBT under 50% of GDP and under 200% of the current account receipts? SUFFICIENT level of foreign exchange RESERVES relative to short-term debt SUPPORTIVE GOV regarding structural reform

Question 28

Three approaches to used in determining capital market expectations

Answer 28

Econometrics Economic indicators Checklist

Question 29

Econometric analysis, adva and disadvantages

Answer 29

Advantages: . once established, can be reused. . quite complex and may accurately model real world conditions. . precise quantitative forecasts of economic conditions. Disadvantages: • • • • . difficult and time intensive (expensive) to create. . may not be applicable in future time periods. . Better at forecasting expansions than recessions. . Requires scrutiny of output to verify validity.

Question 30

Economic indicators. Advantages and disadvantages.

Answer 30

``` Advantages: . Available from outside parties. . Easy to understand and interpret. . Can be adapted for specific purposes. . verified by academic research. ``` Disadvantages: . economic relationships change through time. . can be misleading by giving false signals.

Question 31

Checklist approach

Answer 31

Advantages: • • . Simple. . Allows changes in the model over time. Disadvantages: • • • . Requires subjective judgment . . May be time intensive to create . . May not be able to model complex relationships .

Question 32

4 methods of forecasting exchange rates:

Answer 32

1. relative purchasing power parity: higher inflation - lower future value of currency. (2) relative economic strength: Higher growth and interest rates - strengthen the currency value (3) capital flows: Capital flowing into a market (e.g. US stocks) lead to higher value of USD (4) savings and investment imbalances: When savings are insufficient to fund investments, foreign investment should be attracted by appreciation of local currency.

Question 33

Shorter historical sample may be unduly

Answer 33

influenced by the time span chosen.

Question 34

A longer time span of historical data would increase the

Answer 34

precision of population parameter estimates.

Question 35

In time series analysis, forecasts are generated using

Answer 35

previous values of a variable and previous values of other variables.

Question 36

Beta i =

Answer 36

Correl i,M x standdev i / standdev M

Question 37

Covariance =

Answer 37

Cov i,j = beta i x beta j x standdevM ^2

Question 38

Who performs well during periods of falling inflation or deflation

Answer 38

Bonds, as long as credit risk does not increase.

Question 39

Current account deficit - definition and risks

Answer 39

Imports minus exports problematic because the deficit must be financed through external borrowing

Question 40

Econometric models

Answer 40

system of equations that can capture the fact that GDP is a function of many variables, both current and lagged values

Question 41

Exception to the positive correlation between short term and long term rates

Answer 41

If short-term rates increase enough such that a recession becomes more likely, the yields on bonds will fall as investors anticipate that the demand for loanable funds will fall.

Question 42

Exception to positive correlation between currency and interest rates

Answer 42

if interest rates increase high enough to slow down the economy - investors shy away from the country because the country becomes a less attractive place to invest.

Question 43

Inventory to sales ratio can decline due to

Answer 43

Less optimistic businesses expecting a recession Adoption of just-in-time inventory management approach.

Question 44

short-term interest rates and flat bond yields in what phase of economic cycle?

Answer 44

Early upswing

Question 45

Oil shock stages

Answer 45

(1) a reduction in oil production as a result of turmoil in the Middle East, (2) leading to higher oil prices and inflation, (3) reduced consumer spending, (4) increased unemployment, and (5) a slowed economy. (6) An oil shock could also be a reduction in oil prices resulting in the opposite effects.

Question 46

Financial crisis stages

Answer 46

(1) a country not being able to meet its debt payment, (2) a currency devaluation, or (3) a significant reduction in asset prices. (4) Banks usually become vulnerable in a financial crisis.

Question 47

tools for formulating capital market expectations

Answer 47

``` formal tools: . statistical tools, . discounted cash flow models, . risk premium approach, . financial market equilibrium models ``` survey panel methods judgment - economic and psychological insight

Question 48

Nominal income =

Answer 48

Real income + inflation

Question 49

Almost in all factors have inverse impact on equities vs bonds, except...

Answer 49

Steep drop in Corporate profits ... A decline would lead to both lower equities and bonds.