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

ECONOMICS ANSWERS Question 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: point each for identifying the two tools 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: 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: point for recession and 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 Part A Fed model: S&P earnings yield = 81/1221 = 6.6% 6.6  2.2 >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: point each, for disagreeing that each model indicates overvaluation points for each set of calculations Note that if you not show your calculations these points are not earned If you set up the calculation correctly but then make a mistake, point It is not required to write out the formula and it takes time to 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: points for relating repurchase to dividends or increased cash flow to shareholders and 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 Div1 P Rˆ i   i  g  S     P0 E 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 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 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  B does well as the coupons and principal are nominally fixed but increase in purchasing power ii 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 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 nearzero 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 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 ... was producing no economic benefit and increases return Question 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.. .Question Part A Fed model: S&P earnings yield = 81/1221 = 6.6% 6.6  2.2 >1.0, indicates the earnings... 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