Reading 14 Capital Market Expectations FinQuiz.com FinQuiz.com CFA Level III Item-set - Solution Study Session June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading 14 Capital Market Expectations FinQuiz.com FinQuiz Level III 2018 – Item-sets Solution Reading 14: Capital Market Expectations Question ID: 12514 Correct Answer: B Quicksilver is using a biased estimate of ex ante risk This is because bond prices in the historical period used to set expectations reflected the possibility of a negative event (increase in inflation due to implementation of the monetary policy) that did not materialize during the period Hence, looking backward, Quicksilver has most likely underestimated ex ante risk and overestimated ex ante returns (because the bank policy change did not occur it was overlooked as a risk that was faced by bond investors at that time) Quick silver is also subject to a data measurement bias Private equity indices are usually based on appraisal data that tend to be less volatile than market-determined values (this is true for most alternative investments since transaction based prices are not available and because they are not traded on exchanges with continuously observable prices) Hence, the true standard deviation and the true correlations with other assets are biased downwards Question ID: 12515 Correct Answer: A Douglas’s strategy is incorrect Douglas is incorrectly using the high correlation estimate to assume that an increase in FDI causes stock prices to rise Correlation estimates cannot be used to interpret cause and effect relationships (it could also be that an increase in stock market prices causes more FDI investment in the country) Rose’s strategy is incorrect Rose is using the average beta over the past seven years to estimate returns However, it is highly likely that the historical period includes an expansion phase and a recession phase (a business cycle is usually completed in five to seven years), and betas are different during the different phases Using an average beta may be inappropriate in such a case: returns derived using it are an unconditional benchmark Rose should condition her forecasts on the state of the economy to formulate the most accurate expectations Question ID: 12516 Correct Answer: A Collins has fallen into the status quo trap, since he is focusing on the most recent period only and predicting a continuation of the most recent trend: an increase in prices for technology stocks Rose has fallen into the prudence trap By asking Collins to trim his expectations to be more conservative just because other analysts have pessimistic views (she doesn’t want to make a forecast that might turn out to be wrong and harm her career) without real supporting analysis, Rose has fallen into the prudence trap FinQuiz.com © 2018 - All rights reserved Reading 14 Capital Market Expectations FinQuiz.com Question ID: 12517 Correct Answer: A Rose is incorrect with respect to her advice The discounted cash flow models not address short-run factors such as current supply and demand conditions, so they are more appropriate for setting long-term rather than short term expectations Since Douglas wants to invest for the next seven months or so, the DCF models may not be appropriate Rose is incorrect with respect to the proxy for growth The DCF models (the Gordon growth model) generally use the growth rate in nominal gross domestic product (nominal GDP) as a proxy for growth Nominal GDP growth is the sum of the estimated real growth rate in GDP plus the expected long-run inflation rate Question ID: 12518 Correct Answer: C The real GDP growth rate equals: 2.3+1.3= 3.6% The nominal earnings growth rate equals: 3.6+2.5=6.1% Repricing return = –1.56% Total return = income return +nominal growth rate + repricing return 12.67% = income return + 6.1%–1.56% Income return = 8.13% Question ID: 12519 Correct Answer: B Expected income return = 3.2+0.75 = 3.95% Expected nominal earnings growth return = 3.2%+ 0.97% = 4.17% Repricing return = –0.16% Total return = 3.95 + 4.17% –0.16% = 7.96% FinQuiz.com © 2018 - All rights reserved .. .Reading 14 Capital Market Expectations FinQuiz. com FinQuiz Level III 2018 – Item- sets Solution Reading 14: Capital Market Expectations Question ID: 12 514 Correct Answer: B... 8. 13% Question ID: 12519 Correct Answer: B Expected income return = 3. 2+0.75 = 3. 95% Expected nominal earnings growth return = 3. 2%+ 0.97% = 4.17% Repricing return = –0.16% Total return = 3. 95... Question ID: 12518 Correct Answer: C The real GDP growth rate equals: 2 .3+ 1 .3= 3. 6% The nominal earnings growth rate equals: 3. 6+2.5=6.1% Repricing return = –1.56% Total return = income return +nominal