Reading 14 Capital Market Expectations FinQuiz.com FinQuiz.com CFA Level III Item-set - Question 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 Item-set ID: 12513 Questions 1(12514) through 6(12519) relate to Reading 14 Christine Rose Case Scenario Christine Rose is a portfolio manager currently in the process of determining an appropriate asset allocation for her $15 million portfolio Rose knows that capital market expectations are an essential input to formulating a strategic asset allocation since it helps determine the risk and return prospects of various asset classes To help her with forming these expectations, Rose hired Laura Quicksilver, an economist with a vast experience of working with portfolio managers Rose is going to use the past five years as a historical benchmark to form her expectations During that period, the central bank planned to reduce interest rates to increase economic growth This policy would have increased inflation to double digit figures, but growth increased without the need to implement the policy When Rose inquired about her views, Quicksilver made the following comment: Statement 1: “Looking back at the historical prices and returns of bonds we can expect bonds to earn high returns in excess of the short-term interest rates In addition, using values of private equity indices, I found out that not only they yield high returns with low risk, but they also have a very low correlation with traditional asset classes Hence, private equity could be a good return enhancement and diversification tool.” Rose visited Hal Douglas, a portfolio manager and her colleague at the firm, to get his perspective about the performance of different asset classes Douglas made the following comment: Statement 2: “According to my research, there is a high correlation between foreign investment in the country and stock returns; an increase in foreign direct investment results in an increase in stock market returns Since I expect FDI in the country to rise, I will increase the weight of stocks in my portfolio.” Rose disagreed and made the following comment: Statement 3: “Using an average of the beta of growth stocks over the past seven years, the expected return for this asset class equals 9.5% However, the actual realized return over the same period was 7.8% Hence, this asset class inadequately rewards risk and its weight should be reduced.” Rose and Douglas are working together as investment advisers to Justin Collins, a high-networth private client of their firm During a telephonic conversation with Rose, Collins expressed his interest in investing in technology stocks due a recent rise in stock prices of large multinational technology firms in the country Rose told Collins to reconsider his growth FinQuiz.com © 2018 - All rights reserved Reading 14 Capital Market Expectations FinQuiz.com estimates for such stocks since most analysts following these firms have pessimistic views about their stock prices and expect their growth to fall to single digit figures by the next year Douglas is trying to determine the asset prices for a few manufacturing firms in which he plans to invest for the next seven months or so He wants to choose an appropriate tool for setting capital market expectations to short list amongst the firms Rose advised him to use the discounted cash flow model to set return expectations for the stocks under analysis She also stated that such models give accurate estimates since they use the growth in real GDP as a proxy for stock market growth Douglas is also trying to assess the sources of historical returns for information technology firms in the U.S Exhibit shows some of the information Douglas gathered based on his research of past information Exhibit Compound growth rate over past ten years 12.67% Labor productivity growth 2.3% Labor supply growth 1.3% Inflation rate 2.5% Repricing return –1.56% When Douglas discussed his analysis of historical returns with Rose, she mentioned her current assignment of forming long-term return expectations for Australian stocks Rose has gathered the following statistics: Based on a well-diversified Australian stock index, the dividend yield is expected to be 3.2% A repurchase yield of 0.75% is expected Growth in nominal GDP is expected to be 3.2% with a long-term inflation expectation of 2.1% The premium for corporate growth is 0.97% P/E multiples are expected to fall at a rate of 0.16% Rose will use her forecasts to make comparisons between Australian stock returns and other developed market equity returns FinQuiz Question ID: 12514 With respect to Statement 1, Quicksilver is most likely: A misinterpreting correlations and is subject to the time-period bias B using a biased estimate of ex ante risk and is subject to a data measurement bias C using non-stationary data and is subject to the anchoring trap FinQuiz.com © 2018 - All rights reserved Reading 14 Capital Market Expectations FinQuiz.com FinQuiz Question ID: 12515 Are Douglas’s and Rose’s strategies for changing the allocation of stocks in their portfolios most likely correct? A No B Only Douglas’s strategy is correct C Only Rose’s strategy is correct FinQuiz Question ID: 12516 With respect to the telephonic conversation with Collins, have Rose and Collins most likely fallen into the status quo trap? A Only Collins has fallen into the trap B Only Rose has fallen into the trap C Both Collins and Rose have fallen into the trap FinQuiz Question ID: 12517 Are Rose’s comments to Douglas with respect to his investment in manufacturing firms most likely incorrect? A Yes B Only with respect to her advice C Only with respect to the proxy for growth FinQuiz Question ID: 12518 Using Exhibit 1, the return from income was closest to: A 5.01% B 5.42% C 8.13% FinQuiz Question ID: 12519 The expected income return and total return on Australian equities are closest to: A 4.17% and 10.38% respectively B 3.95% and 7.96% respectively C 3.36% and 6.99% respectively FinQuiz.com © 2018 - All rights reserved .. .Reading 14 Capital Market Expectations FinQuiz. com FinQuiz Item- set ID: 125 13 Questions 1(12 514) through 6(12519) relate to Reading 14 Christine Rose Case Scenario... non-stationary data and is subject to the anchoring trap FinQuiz. com © 2018 - All rights reserved Reading 14 Capital Market Expectations FinQuiz. com FinQuiz Question ID: 12515 Are Douglas’s and Rose’s... return on Australian equities are closest to: A 4.17% and 10 .38 % respectively B 3. 95% and 7.96% respectively C 3. 36% and 6.99% respectively FinQuiz. com © 2018 - All rights reserved