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

Applications of Economic Analysis to Portfolio Management Test ID: 7427706 Question #1 of 99 Question ID: 465348 Suppose an analyst is valuing two markets Market A is a developed country market and Market B is an emerging market What is the expected return for the emerging market given the following information? Sharpe ratio of the global portfolio 0.29 Standard deviation of the global portfolio 8.00% Risk-free rate of return 4.00% 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% ᅞ A) 8.35% ᅚ B) 12.35% ᅞ C) 9.85% Explanation For practice, we calculate the expected returns for both markets First, we calculate the equity risk premium for both markets assuming full integration Note that for the emerging market, the illiquidity risk premium is added in: 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? ᅚ A) Business spending is less volatile than consumer spending ᅞ B) As a percentage of GDP, consumer spending is much larger than business spending ᅞ C) 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 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 Question #3 of 99 Question ID: 465367 Which asset would perform the worst during deflationary periods? ᅚ A) Real estate financed with debt ᅞ B) Corporate bonds ᅞ C) Real estate wholly owned Explanation Deflation reduces the value of investments financed with debt In the case of real estate, if the property is levered with debt, losses in its value lead to steeper declines in the investor's equity position As a result, investors flee in an attempt to preserve their equity and prices fall further Bond prices will rise during deflationary periods when inflation and interest rates are declining Question #4 of 99 Question ID: 465410 Using the data provided, rank the following variables in descending order of their impact on real economic output: change total factor productivity (TFP), change in labor input (labor), and change in capital input (capital) Expected growth in real economic output Expected growth in total factor productivity Expected growth in the labor Expected growth in capital stock, α = 0.4 2% 1% 1% 1% ᅚ A) TFP, labor, capital ᅞ B) Capital, TFP, labor ᅞ C) Labor, capital, TFP Explanation 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 in each 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 in labor %ΔY = %ΔA + α(%ΔK) + (1 − α)(%ΔL) = 1.0% + 0.4(1.0%) + (0.6)(1.0%) Question #5 of 99 Question ID: 465384 An analyst believes that a recession is likely to develop that will affect many of the world economies She believes that Country A's GDP should be forecast using current and lagged economic data for it as well as from other countries that may influence Country A What type of country is Country A and what type of forecasting model should be used? Country A is most likely a: ᅞ A) small country and its GDP should be forecast using a checklist approach ᅚ B) small country and its GDP should be forecast using an econometric approach ᅞ C) 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 economies are less affected by events in other countries An econometric approach can be very complex, involving several data items of various time periods lags to predict the future They can be used to accurately model real world conditions Question #6 of 99 Question ID: 465374 Calculate the short-term interest rate target given the following information Neutral rate 4.00% Inflation target 2.00% Expected Inflation 5.00% GDP long-term trend 3.00% Expected GDP 1.00% ᅞ A) 5.0% ᅞ B) 6.5% ᅚ C) 4.5% Explanation The weak projected economic growth calls for cutting interest rates If inflation were not a consideration, the target interest rate would be 1% lower than the neutral rate However, the higher projected inflation overrides the growth concern and the targeted rate is actually higher than the neutral rate Question #7 of 99 Question ID: 465405 During which phase of the business cycle would TIPS be least useful to a portfolio manager? ᅚ A) Initial recovery ᅞ B) Slowdown ᅞ C) Early expansion Explanation U.S Treasury Inflation Protected Securities (TIPS) are protected against increases in inflation They would be needed the least when inflation is falling During the initial recovery phase of the business cycle, inflation is falling Question #8 of 99 Question ID: 465402 Which of the following statements regarding the relationship between a domestic currency value and interest rates is most accurate? ᅞ A) An increase in short-term interest rates decreases the value of the domestic currency ᅚ B) An increase in short-term interest rates may increase or decrease the value of the domestic currency ᅞ C) An increase in short-term interest rates increases the value of the domestic currency Explanation Higher interest rates generally attract capital and increase the domestic currency value At some level though, higher interest rates will result in lower currency values because the high rates may stifle an economy and make it less attractive to invest there Question #9 of 99 Which of the following would indicate that a country is less affected by global events? The country is: ᅚ A) large and has a diversified economy ᅞ B) small and has a diversified economy ᅞ C) small and has an undiversified economy Question ID: 465385 Explanation Larger countries with diverse economies are less affected by events in other countries Small countries with undiversified economies are more susceptible to global events Question #10 of 99 Question ID: 465366 Which phase of the business cycle is characterized by rising stock prices but increased investor nervousness? ᅞ A) Slowdown ᅞ B) Initial recovery ᅚ C) Late expansion Explanation The late expansion phase of the business cycle is characterized by high confidence and employment, increases in inflation, rising bond yields, and rising stock prices Investor nervousness increases risk during this period The central bank also limits the growth of the money supply Question #11 of 99 Question ID: 465427 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? ᅞ A) The spread between the S&P 500 earnings yield and the Treasury notes is too great to make an informed decision ᅞ B) Since the S&P 500 is earning significantly more than the Treasuries this indicates the S&P 500 equity market is overvalued ᅚ 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 value Question #12 of 99 Question ID: 465350 Suppose the analyst estimates a 1.8% dividend yield, long-term inflation of 3.4%, real earnings growth of 5.0%, an increase in shares outstanding of 0.6%, and a P/E repricing of 0.2% What would be the expected return on the stock market? ᅞ A) 11.0% ᅚ B) 9.8% ᅞ C) 8.6% Explanation The expected return on the stock market is 1.8% + 3.4% + 5.0% - 0.6% + 0.2% = 9.8% Question #13 of 99 Question ID: 465422 Which of the following statements regarding Tobin's q and the equity q is least accurate? ᅚ A) The equity q compares the aggregate market value of the firm's equity to the market value of the firm's net worth ᅞ B) The equilibrium value for both Tobin's q and the equity q is ᅞ C) 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 aggregate market value of the firm'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 Question #14 of 99 Question ID: 465412 The following data pertains to an equity market index Last dividend (D0) 100 Forecast earnings per share 300 Current and sustainable long-term growth rate 2.5% Required return 7.5% 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: ᅞ A) 2,929 ᅚ B) 2,050 ᅞ C) 2,000 Explanation We are provided with a constant rate of growth, so we can use the constant growth dividend discount model for equity valuation: Questions #15-20 of 99 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 managers The analysts use Fellows' forecasts as the basis for their own research on specific securities or asset classes However, Fellows is concerned that his forecasts are not accurate enough In an effort 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: Establish a benchmark for market expectations Multinational serves thousands of clients with different investment goals and constraints, and Fellows knows analysts will need the different benchmarks for a variety of different types of investors Look at the historical returns of a number of asset classes to act as a check on forecasts for each asset class Assemble data on historical returns and valuations for all relevant asset classes, considering potential biases, adjusting the numbers to account for different calculation methods, and ensure that data definitions match those used by the company that collected the data Interpret the data Fellows uses his years of experience to extrapolate that data into growth and valuation assumptions for each asset class This step is the most subjective Distill assumptions into top-down forecasts, detailing the assumptions and methods for interpreting historical data in the event that individual analysts want to use data to create their own industry-specific forecasts 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 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 inflation picture to Carol Huggins, a colleague who works in the bank's money-management business Huggins consults on money-management issues with large clients and is very interested in inflation projections Lester Canfield, 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 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 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 advises against the move into high yield bonds Question #15 of 99 Question ID: 485070 Fellows skipped a step in his technique for producing forecasts He forgot to: ᅞ A) assure that the underlying data is accurate ᅞ B) identify where he obtained his data ᅚ 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 five of Fellows' process (Study Session 7, LOS 16.a) Question #16 of 99 Question ID: 485071 Fellows' advice to Canfield suggests Canfield is least likely suffering from: ᅞ A) the prudence trap ᅚ B) the recallability trap ᅞ C) 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 with allowing dramatic events to affect forecasts This issue is not relevant here (Study Session 7, LOS 16.b) Question #17 of 99 Question ID: 485072 Andrews most likely requested bond yields because she wanted to: ᅞ A) gauge potential fixed-income investments ᅞ B) develop a shrinkage estimate ᅚ C) 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 equity trader, 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) Question #18 of 99 Which of the following is least likely a common problem encountered in forecasting? Question ID: 485073 ᅞ A) Data measurement errors and biases ᅚ B) It is difficult to use multiple regression analysis ᅞ C) Failing to account for conditioning information Explanation There are nine problems in producing forecasts: limitations to using economic data data measurement error and bias limitations of historical estimates the use of ex post risk and return measures non-repeating data patterns failing to account for conditioning information misinterpretations of correlations psychological traps model and input uncertainty Due 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 (Study Session 7, LOS 16.b) Question #19 of 99 Question ID: 485074 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? ᅚ A) Initial recovery ᅞ B) Slowdown ᅞ C) Late expansion Explanation In general, inflation 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 (Study Session 7, LOS 16.e) Question #20 of 99 Question ID: 485075 Which of the following is least accurate regarding inflation? ᅚ A) Low inflation affects the return on cash instruments ᅞ B) Declining inflation results in declining economic growth and asset prices ᅞ C) 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 are highly levered because they are most sensitive to changing interest rates Low inflation does NOT affect the return on cash instruments (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? ᅞ A) Monetary policy is expansive while fiscal policy is restrictive ᅞ B) Monetary policy is restrictive and fiscal policy is restrictive ᅚ C) 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 are lower than long-term rates), and the economy is likely to expand in the future Question #22 of 99 Question ID: 465381 Which of the following statements least likely represents a scenario from an exogenous shock? ᅞ A) 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 ᅚ B) OPEC not being able to agree on production levels leading to increased uncertainty in global markets and increased oil prices ᅞ C) 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 the least severe outcome of the answer choices Exogenous shocks usually lead to economic slowdowns, as in the case of an oil shock leading to higher prices, inflation, reduced consumer spending, increased unemployment, and a slowing economy A reduction in oil prices could be caused by a weak global economy with weak demand for oil or an oversupply of oil in the global market This would reduce the price of oil and boost the economy, potentially overheating it in which causes high inflation and increased interest rates that ultimately slow the economy down In a financial crisis the result is usually characterized by banks becoming vulnerable and requiring action by the central bank to stabilize the banking system and economy by increasing liquidity and lowering interest rates Question #23 of 99 Question ID: 465407 Which of the following statements about the Cobb Douglas production function is least accurate? The Cobb-Douglas production function assumes the: ᅞ A) growth in total factor productivity (TFP) is zero when constant returns to scale are present ᅞ B) output elasticities of capital and labor, α and β, sum to 1.0 ... variance of the stock and bond factors are 0.04 and 0. 007 respectively The covariance of the two factors is 0.01 Litner and Cabell will use these results to forecast the covariance of the returns of. .. the stocks, they compose a model using those variables to predict the returns of the stocks Litner and Cabell also perform a factor analysis of stocks FGI and VCC Using a world index "S" and a... 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