Capital Markets

Question 1

Cross-sectional consistency

Answer 1

Refers to consistency across asset classes regarding portfolio risk and return characteristics

Question 2

Intertemporal consistency

Answer 2

Refers to consistency over various investment horizons regarding portfolio decisions over time

Question 3

Limitations to using economic data when forecasting

Answer 3

• The time lag between collection and distribution is often quite long.
• Data are often revised and the revisions are not made at the same time as the publication
• Data indexes are often rebased over time

Question 4

Transcription Errors

Answer 4

The misreporting or incorrect recording of information and are most serious if they are biased in one direction

Question 5

Survivorship Bias

Answer 5

Commonly occurs if a manager or a security return series is deleted from the historical performance record of managers or firms

Question 6

Appraisal Data

Answer 6

Appraisal data for illiquid and infrequently priced assets makes the path of returns appear smoother than it actually is. This biases downward calculated standard deviation and makes the returns seem less correlate (closer to 0) with more liquid priced assets

Question 7

Limitations of Historical Estimates

Answer 7

Can hamper the formation of capital market expectations.

Question 8

Why is a long time period preferable when working with historical data

Answer 8

• It may be statistically required: to calculate historical covariance (and correlation), the number of data points must exceed the number of covariances to be calculated
• A larger data set (time period) provides more precise statistical estimates with smaller variance to the estimates
• Using a short time period creates a temptation to us more frequent data, such as weekly data, rather than monthly data point in order to have a larger sample size

Question 9

ex post data (after the fact)

Answer 9

also known as actual returns, is information about the results of an event that has already taken place. It’s often used by investment companies to calculate the actual returns of a security, which can help them predict future earnings.

Question 10

ex ante (before the fact)

Answer 10

refers to future events that are based on forecasts or predictions rather than concrete results. Translated from Latin, it means before the event.

Question 11

Misinterpretation of correlation

Answer 11

A problem in forming capital market expectations; a common mistake that can lead to ineffective strategies and wasted resources. Here are some ways correlation can be misinterpreted

Question 12

Psychological biases

Answer 12

a systematic error in thinking that occurs when people process and interpret information in their surroundings, influencing their decisions and judgments

Question 13

Anchoring Bias

Answer 13

When the first information received is overweight.

Question 14

Status Quo Bias

Answer 14

When predictions are highly influenced by the recent past

Question 15

Confirmation Bias

Answer 15

When only information supporting the existing belief is considered, and when such evidence may be actively sought while other evidence is ignored.

Question 16

Overconfidence Bias

Answer 16

When past mistakes are ignored, the lack of comments from others is taken as agreement, and when the accuracy of forecast is overestimated

Question 17

Prudence Bias

Answer 17

When forecasts are overly conservative to avoid the regret from making extreme forecasts that could end up being incorrect

Question 18

Availability Bias

Answer 18

When what is easiest to remember (often an extreme event) is overweighted

Question 19

Model Uncertainty

Answer 19

Refers to selecting the correct model.

Question 20

Parameter Uncertainty

Answer 20

Refers to estimation errors in model parameters

Question 21

Input Uncertainty

Answer 21

Refers to knowing the correct input values for the model

Question 22

Question:

An analyst uses a variety of valuation approaches for different asset classes and collects the necessary data from multiple sources. The analyst does not make any effort to systematically compare the data used. As a result, the analyst uses relatively low discount rates for equity analysis (overestimating theoretical value) and high discount rates for fixed income (underestimating theoretical value). Discuss the likely effect on the analyst’s asset
allocation recommendations.

Answer 22

The analyst has not been systematic and has used inconsistent assumptions. In this case, the result is overstating the attractiveness of equity and understating the attractiveness of fixed income. The result would be allocating too much to equity

Question 23

Question:

An analyst would like to forecast U.S. equity returns. He is considering using either the last 3 years of historical annual returns or the last 50 years of historical annual returns. Provide an argument for and against each selection of data length.

Answer 23

Pro: The recent three-year period is more likely to reflect the current economic and political environment.

Con: The recent shorter period does not reflect the full course of a business cycle or a variety of possible economic conditions.

Pro: The longer period is more likely to reflect various economic conditions that can occur.

Con: The longer period is more likely to be subject to regime change, be nonstationary, and reflect conditions that are no longer relevant.

Question 24

Question:

Explain why smoothed data may be present for some types of alternative investments and the consequences for their risk and correlation with other assets from using such data.

Answer 24

Some types of alternative investments are not regularly traded, and only infrequent prices (smoothed data) are available. This makes the calculated standard deviation lower because there are no actual periodic changes in value (there are no prices to examine). The smoothed return data also appears to be less correlated with the more erratic pricing of other asset classes that have and report actual trading prices. The correlation will appear closer to zero.

Question 25

Exogenous Shocks

Answer 25

Are unanticipated events that occur outside the normal course of an economy. Because the events are unanticipated, they are not already built into current market prices, whereas normal trends in an economy, which would be considered endogenous, are built into market prices.

Question 26

What factors can cause Exogenous Shocks?

Answer 26

Changes in government policies
Political events
Technological progress
Natural disasters

Question 27

Changes in Government Policies

Answer 27

Government policies that can encourage long-term growth include sound fiscal policy, minimal government interference with free markets, facilitating competition in the private sector, development of infrastructure and human capital, and sound tax polices

Question 28

Political Events

Answer 28

Geopolitical tensions that divert resources to less productive use may lead to decreases in growth. Conversely, cuts in defense spending due to higher levels of world peace may lead to increase in growth

Question 29

Technological progress

Answer 29

The creation of new and innovative markets, products, and technologies has the potential to improve growth

Question 30

Natural Disasters

Answer 30

Natural disasters likely reduce short-term growth, but may (arguably) encourage long-term growth if more efficient capacity replaces previous capacity

Question 31

Discovery of Natural Resources

Answer 31

Production of new natural resources or the introduction of new ways to recover existing resources can enhance growth. In addition, decreases in resource production costs will improve growth while decreases in resource supply will restrict growth

Question 32

Financial Crises

Answer 32

Shocks to the financial system will lead to a crisis of confidence among market participants. Financial crises may reduce the level of economic output in the short term and may also decrease the trend rate of growth

Question 33

Key Considerations of Economic Growth Trend Analysis

Answer 33

1. Forecasting returns with DCF models incorporate the trend rate pf growth.
2. Higher trend growth rates may lead to higher stock returns assuming the growth is not already reflected in stock prices
3. When we speak of higher trend growth rates, we mean the economy can grow at a faster pace before inflation becomes a major concern. This consideration influences monetary policy and the level of bond yields.
4. Higher trend growth rates tend to generate higher government bond yields

Question 34

Basic Model for Forecasting the Economic Growth Rate:

Answer 34

• Labor Input
• Capital per Worker
  *Total Factor Productivity
  (more info below)

Question 35

Labor Input

Answer 35

Based on growth in the labor force and labor participation. Growth in the labor force depends on population growth and demographics. Labor participation refers to the percentage of the population working and is affected by real wages, work/leisure decisions, and social factors

Question 36

Capital per Worker

Answer 36

Which increases labor productivity

Question 37

Total Factor Productivity

Answer 37

Which is reflected in technological progress and changes in government policies

Question 38

Forecasting the long-term economic growth rate (example)

Assume that the population is expected to grow by 2% and that labor force participation is expected to grow by 0.25%. If spending on new capital inputs is projected to grow at 2.5% and total factor productivity will grow by 0.5%, what is the long-term projected growth rate?

Answer 38

The sum of the components equals 2% + 0.25% + 2.5% + 0.5% = 5.25%
The economy is projected to grow by 5.25%

Question 39

Three Approaches to Economic Forecasting

Answer 39

1. Econometric Modeling
2. Use of Economic Indicators
3. A Checklist Approach

Question 40

Econometric Analysis

Answer 40

Uses statistical methods to explain economic relationships and formulate forecasting models

Question 41

Structural Models

Answer 41

Are based on economic theory

Question 42

Reduced-Form Models

Answer 42

Are compact versions of structural approaches

Question 43

Advantages of Econometric Analysis

Answer 43

1. Modeling can incorporate many variables
2. Once the model is specified, it can be reused
3. Output is quantified and based on a consistent set of relationships

Question 44

Disadvantages of Econometric Analysis

Answer 44

1. Models are complex and time-consuming to construct
2. The data may be difficult to forecast and the relationships can change
3. Output may require interpretation or by unrealistic
4. It does not work well to forecast turning points

Question 45

Economic Indicator

Answer 45

Are available from governments, international organizations (e.g., the Organization of Economic Cooperation and Development), and private organizations (e.g., the Conference Board in the United States).

Question 46

Leading Indicators

Answer 46

These are measurements that anticipate future events and help predict performance before it happens. They move ahead of the business cycle with a reasonable stable lead time.

Question 47

Composite

Answer 47

A group of portfolios that are managed with a similar investment strategy, objective, or mandate. It’s often used to present performance to potential clients. Composites can by used with Leading Indicators, and can be interpreted as a diffusion index.

Question 48

Diffusion Index

Answer 48

A measure of how many stocks are advancing within an index, typically on a daily basis. It can also be used to measure the extent of economic expansions by calculating the proportion of component indicators that are improving.

Question 49

Coincident Indicator

Answer 49

A statistic that reflects the current state of the economy in real-time. Coincident indicators are used to help make informed decisions about business strategies and economic policies.

Question 50

Lagging Indicators

Answer 50

These are measurements of past and current results and performance that confirm trends and changes in trends. They are used to confirm economic or market shifts that are already in motion and are sometimes called “output” metrics.

Question 51

Advantages of Economic Indicators

Answer 51

1. Economic indicators are simple, intuitive, and easy to interpret
2. Data is often readily available from third parties
3. Indicator lists can be tailored to meet specific forecasting needs

Question 52

Disadvantages of Economic Indicators

Answer 52

1. Forecasting results have been inconsistent
2. Economic Indicators have given false signals
3. Indicators are revised frequently, which can make them appear to fit past business cycles better than they did when the data was first released

Question 53

Checklist Approach

Answer 53

Ensures that no critical detail is overlooked, streamlines the investment process, and creates a culture of consistency and accountability, leading to maximized returns, reduced errors, and a competitive edge in the market.

Question 54

Advantages of Checklist Approach

Answer 54

1. Less complex than econometrics
2. Flexible in mixing objective statistical analysis with judgment to incorporate changing relationships

Question 55

Disadvantages of Checklist Approach

Answer 55

1. Subjective
2. Time-consuming
3. Complexity must be limited due to manual process

Question 56

Business Cycle

Answer 56

A type of fluctuation found in the aggregate economic activity of a nation—a cycle that consists of expansions occurring at about the same time in many economic activities, followed by similarly general contractions. This sequence of changes is recurrent but not periodic. The business cycle is also called the economic cycle.

Question 57

Disadvantages of Business Cycle

Answer 57

1. Business cycles vary in duration and intensity, and their turning points are difficult to predict. Their variations may be thought of as resulting from the interactions of many subcycles with a wide range of frequencies.
2. Although we typically think of and model economic activity in terms of cycles fluctuation around a long-term trend, it can be difficult to distinguish which effects result from shorter-term factors that arise from the business cycle and which are related to longer-term factors that affect the trend rate of economic growth.
3. Returns in the capital market are strongly related to activity in the real economy, but they also depend on factors such as investors’ expectations and risk tolerances.

Question 58

Advantages of Business Cycle

Answer 58

Business cycle analysis is most useful for identifying opportunities within the time horizon of a typical business cycle. For longer investment horizons that are likely to include one or more full business cycles, information about the current state of the economy is less valuable.

Question 59

Five phases of the Business Cycle

Answer 59

1. Initial Recovery
2. Early Expansion
3. Late Expansion
4. Slowdown
5. Contraction

Question 60

Characteristics of INITIAL RECOVERY of the Business Cycle

Answer 60

• Duration of a few months
• Business confidence rising
• Government stimulus provided by low interest rates and/or budget deficits
• Falling inflation
• Larger output gap
• Low or falling short-term interest rates
• Bond yields bottoming out
• Rising stock prices
• Cyclical, riskier assets such as small-cap stocks and high yield bonds doing well

Question 61

Characteristics of EARLY EXPANSION of the Business Cycle

Answer 61

• Duration of a year to several years.
• Increasing growth with low inflation.
• Increasing confidence.
• Rising short-term interest rates.
• Output gap is narrowing.
• Stable or rising bond yields.
• Rising stock prices

Question 62

Characteristics of LATE EXPANSION of the Business Cycle

Answer 62

• High confidence and employment.
• Output gap eliminated and economy at risk of overheating.
• Increasing inflation.
• Central bank limits the growth of the money supply.
• Rising short-term interest rates.
• Rising bond yields.
• Rising/peaking stock prices with increased risk and volatility.

Question 63

Characteristics of SLOW DOWN of the Business Cycle

Answer 63

• Duration of a few months to a year or longer.
• Declining confidence.
• Inflation still rising.
• Short-term interest rates at a peak.
• Bond yields peaking and possibly falling, resulting in rising bond prices.
• Possible inverting yield curve.
• Falling stock prices.

Question 64

Characteristics of CONTRACTION of the Business Cycle

Answer 64

• Duration of 12 to 18 months.
• Declining confidence and profits.
• Increase in unemployment and bankruptcies.
• Inflation topping out.
• Falling short-term interest rates.
• Falling bond yields, rising prices.
• Stock prices increasing during the latter stages, anticipating the end of the recession.

Question 65

Inflation

Answer 65

Inflations means generally rising prices

Question 66

Disinflation

Answer 66

Disinflation means a deceleration in the rate of inflation

Question 67

Deflations

Answer 67

Deflation means generally falling prices.

Question 68

Deflation is a severe threat to economic activity for the following reasons:

Answer 68

• It encourages default on debt obligations
• With negative inflation, interest rates decline to near zero and this limits the ability of central banks to lower interest rates and stimulate the economy

Question 69

Quantitative Easing (QF)

Answer 69

A monetary policy used by central banks to increase the money supply and reduce interest rates. The goal of QE is to stimulate economic activity, particularly during financial crises or recessions.
Traditionally, central banks have used open market operations to increase the money supply and decrease short-term interest rates on a temporary basis by buying high quality fixed-income instruments. QE was different in that it was larger in scale, the purchases included other security types such as mortgage-backed securities and corporate bonds, and the intent was a long-term increase in bank reserves.

Question 70

Inflation within expectations

Answer 70

** Cash equivalents: Earn the real rate of interest
** Bonds: Shorter-term yields more volatile than long-term yields
** Equity: No impact given predictable economic growth
** Real estate: Neutral impact with typical rates of return

Question 71

Inflation above or below expectation

Answer 71

** Cash equivalents: Positive (negative) impact with increasing (decreasing) yields
** Bonds: Longer-term yields more volatile than shorter-term yields
** Equity: Negative impact given the potential for central bank action or falling asset prices, though some companies may be able to pass rising costs on to customers
** Real estate: Positive impact as real asset values increase with inflation

Question 72

Deflation

Answer 72

** Cash equivalent: Positive impact if nominal interest rates are bound by 0%
** Bonds: Positive impact as fixed future cash flows have greater purchasing power (assuming no default on the bond)
** Equity: Negative impact as economic activity and business declines
** Real estate: Negative impact as property values generally decline

Question 73

Question:

An analyst believes that GDP is best forecasted using a system of equations that can capture the fact that GDP is a function of many variables. Which economic forecasting method is the analyst most likely to use?

Answer 73

Econometric analysis would be the best approach to use. It can model the complexities of reality using both current and lagged values. Ordinary least squares regression is most often used, but other statistical methods are also available.

Question 74

Question:

The phase of the business cycle in which we most likely expect to observe rising short-term interest rates and stable bond yields is:

a. Late Expansion
b. Initial Recovery
c. Early Expansion

Answer 74

C Early Expansion:
In this period of the business cycle, we expect to observe rising short-term interest rates and stable or rising bond yields. The expectations of short-term and long-term yields for the other phases are listed as follows:

Late Expansion: Both short-term and long-term rates increase.
Initial Recovery: Low or falling short-term rates, and bond yields have bottomed out

Question 75

Question:

Describe how bonds and equities typically perform during deflationary periods?

Answer 75

Bonds tend to perform well during periods of falling inflation or deflation because interest rates are declining. This holds true as long as credit risk does not increase. Equities do poorly in periods of declining inflation or deflation due to declining economic growth and asset prices.

Question 76

Monetary Policy

Answer 76

Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.
Monetary policy is often used by central banks as a countercyclical force, attempting to optimize the economy’s performance.

Question 77

The neutral rate

Answer 77

The rate at which a balance between growth and inflation is achieved, is also known as the equilibrium interest rate. It is generally thought that the neutral rate is composed of an inflation component and a real growth component. The neutral rate is the rate that most central banks strive to achieve as they attempt to balance the risks of inflation and recession. If inflation is too high, the central bank should increase short-term interest rates. If economic growth is too low, it should decrease interest rates.

Question 78

Taylor Rule

Answer 78

The Taylor Rule (sometimes referred to as Taylor’s rule or Taylor principle) is an equation linking the Federal Reserve’s benchmark interest rate to levels of inflation and economic growth. It determines the target interest using the neutral rate, the expected GDP relative to its long-term trend, and expected inflation relative to its targeted amount.
The formula is expressed as: r = p + 0.5y + 0.5 (p - 2) + 2, where r represents the nominal federal funds rate, p is the rate of inflation, and y is the percent deviation between the current real GDP and the long-term linear trend in GDP

Question 79

Example of Taylor Rule
Calculating the short-term interest rate target:

Answer 79

Given the following information, calculate the nominal short-term interest rate target.
Neutral rate 3%
Inflation target 2%
Expected inflation 4%
GDP long-term trend 2%
Expected GDP growth 0%
Answer:
(n)target = 3% + 2% + [0.5(0% – 2%) + 0.5(4% – 2%)]
= 5% + (–1% + 1%) = 5%

In this example, weak projected economic growth would call for cutting interest rates if inflation were not a consideration. If the central bank was only concerned with growth, the target interest rate would be 1% lower than the neutral rate. However, the higher projected inflation overrides the growth concern because projected inflation is 2% greater than the target inflation rate. In net, the target rate is 5% because the concern over high inflation overrides the weak growth concern

Question 80

Negative Interest Rates

Answer 80

A negative rate is defined as a net payment made to keep money on
deposit at a financial institution or payment of a net fee to invest in short-term instruments

Question 81

QE Approach (Quantitative Easing)

Answer 81

Quantitative easing (QE) is a form of monetary policy in which a central bank, like the U.S. Federal Reserve, purchases securities in the open market to reduce interest rates and increase the money supply.

Quantitative easing creates new bank reserves, providing banks with more liquidity and encouraging lending and investment. In the United States, the Federal Reserve implements QE policies.

Question 82

Negative Interest Rates - complications in the process of forming capital market expectations

Answer 82

• The risk-free rate is the starting point for buildup models used to estimate long-run returns for asset classes. When the risk-free rate is negative, a sustainable expected risk-free rate, such as the policy-neutral rate in the Taylor rule, is more appropriate as that starting point. That rate is generally not regarded as fully risk-free, so a modest default premium can be removed.
• Forming capital market expectations over shorter time horizons is further complicated by a need to forecast the time path over which negative rates will converge to a long-run sustainable risk-free rate. Multiple path projections should be considered to allow for uncertainty regarding how the convergence will occur.

*Another approach to shorter-term projections of asset class returns is to interpret negative risk-free rates as being consistent with contraction or early recovery stages of the business cycle.

*Using historical data as a starting point for forecasting is more problematic because few comparable periods exist, and the negative rates suggest significant structural economic changes are occurring. This kind of regime change makes statistics based on historical data less reliable, requiring more subjective assessments. Anticipating the effects of negative rates when combined with less-tested QE makes forecasting even more challenging.

Question 83

Fiscal Policy

Answer 83

There are two important aspects to fiscal policy. First, it is not the level of the budget deficit that matters—it is the change in the deficit. For example, a deficit by itself does not stimulate the economy, but increases in the deficit are required to stimulate the economy. Second, changes in the deficit that occur naturally over the course of the business cycle are not stimulative or restrictive. In an expanding economy, deficits will decline because tax receipts increase and disbursements to the unemployed decrease. The opposite occurs during a recession. Only changes in the deficit directed by government policy will influence growth.

Question 84

The Yield Curve

Answer 84

The yield curve demonstrates the relationship between interest rates and the maturity of debt securities. The is sensitive to government actions as well as current and expected economic conditions. When both fiscal and monetary policies are expansive, for example, the yield curve is sharply upward sloping (i.e., short-term rates are lower than long-term rates), and the economy is likely to expand in the future.

Question 85

implication for the yield curve if fiscal and monetary policies reinforce or conflict each other

Answer 85

• If both policies are stimulative, the yield curve is steep and the economy is likely to grow
• If both policies are restrictive, the yield curve is inverted, and the economy is likely to contract
• If monetary policy is restrictive and fiscal policy is stimulative, the yield curve is flat and the implications for the economy are less clear
• If monetary policy is stimulative and fiscal policy is restrictive, the yield curve is moderately steep and the implications for the economy are less clear

Question 86

Macroeconomic Links

Answer 86

Refer to the connections and relationships between various large-scale economic factors that influence the overall performance of an economy. These links can include:

1. Goods Markets and Financial Variables: The relationship between the markets for goods and services and financial variables like price levels and interest rates.
2. National and International Markets: How domestic markets are connected to international markets through trade, investment, and capital flows
3. Economic Indicators: The interplay between key economic indicators such as GDP, unemployment rates, and inflation

Can produce convergence in business cycles among economies.

Question 87

Measures of Macroeconomic Linkage

Answer 87

** A country’s current account and capital account
** Interest rates and currency exchange rates

Question 88

Country’s Current Account

Answer 88

The current account is a key component of a country’s balance of payments, which measures the difference between a nation’s savings and its investment.
A useful relationship for understanding how the current account influences economic activity is the following formula:

net exports = net private saving + government surplus

• Imports and exports of goods and services
• Payments made to foreign investors
• Transfers such as foreign aid
• Net income
• It can be in deficit, balanced, or surplus.

Question 89

Question:

During an economic expansion, an analyst notices that the budget deficit has been declining. The analyst concludes that the government’s fiscal policy has shifted to a more restrictive posture. Comment on her conclusion

Answer 89

Her conclusion may not be warranted. In an economic expansion, the budget deficit will decline naturally because tax receipts increase and disbursements to the unemployed decrease. The changes she is observing may be independent of the government’s fiscal policy

Question 90

Question:

Calculate the nominal short-term interest rate target given the following information -

Neutral Real Rate 2%
Inflation Target 3%
Expected Inflation 5%
GDP Long-Term Trend 3%
Expected GDP 4%

Answer 90

(n)target = 2%+5%+[0.5x(4%-3%)+0.5x(5%-3%)]=7%+[0.5%x1%]=8.5%

In this example, the higher-than-targeted growth rate and higher-than-targeted inflation rate argue for a targeted nominal interest rate of 8.5%. This rate hike is intended to slow down the economy and inflation.

Question 91

Question:

A forecaster notes that the yield curve is steeply upwardly sloping. Comment on the likely monetary and fiscal policies in effect and the future of the economy

Answer 91

If the yield curve is steeply upwardly sloping, then it is likely that both fiscal and monetary policies are expansive. The economy is likely to expand in the future.

Question 92

Question:

An analyst is evaluating two countries. Moldavia has a GDP of $60 billion and an economy that is dominated by the mining industry. Ceania has a GDP of 1.2 trillion and an economy that sells a variety of items. He is predicting a global economic slowdown. Which country is at greater risk?

Answer 92

A global economic slowdown would affect smaller countries with undiversified economies more because economic links are more important for these types of countries. Larger countries with diverse economies are less affected by events in other countries.

Question 93

Question:

At a conference, Larry Timmons states that a pegged exchange rate allows a less developed country to achieve greater currency and economic stability, as well as relatively lower and more stable interest rates, and to pursue fiscal and economic policies to maximize the country’s real economic growth. Explain what is correct and incorrect in Timmons’s statement

Answer 93

Greater currency and economic stability: true. The peg is likely to create a more stable currency that provides confidence for investors and businesses, both of which promote economic stability. Maintaining the peg prevents excessive money creation, which holds down inflation and also promotes economic stability. The peg is a commitment to follow the policies needed to maintain the value of the currency.
Relatively lower and more stable interest rates: partially true (or partially false). Interest rates will be related to but higher than the country to which the currency is pegged. The interest rate premium will reflect the investor’s perception of the country’s commitment and ability to maintain the peg. If that comes into question, the country will likely have to increase interest rates in order to maintain the currency value. The goal of the peg is lower and more stable rates, but if the peg fails, the opposite can occur.
Pursue the fiscal and economic policies to maximize the country’s real economic growth: false. The country must largely follow the economic policies of the country to which it is pegged. These may or may not be optimal for the country’s growth.

Question 94

Why do banks often use monetary policy as a countercyclical force?

Answer 94

The goal is to keep growth near its long-run sustainable rate, because growth faster than the long-run rate usually results in increased inflation. To spur growth, a central bank can take actions to reduce short-term interest rates

Question 95

Capital market expectations help in …

Answer 95

• formulating the strategic asset allocation
• assist in detecting short-term asset mispricing exploitable through tactical asset allocation.
  Asset allocation should display both cross-sectional and intertemporal consistency

Question 96

Process to formulate capital market expectations

Answer 96

1. Determine the relevant capital market expectations given the investor’s allowable asset classes and investment horizon(s).
2. Investigate assets’ historical performance as well as the determinants of their performance.
3. Identify the valuation model used and its requirements.
4. Collect the best data possible.
5. Use experience and judgment to interpret current investment conditions.
6. Formulate capital market expectations.
7. Monitor performance and use it to refine the process

Question 97

Central Tendency

Answer 97

a value that aims to describe an entire dataset. The central tendency gives a snapshot of where most values in a dataset tend to cluster. The central tendency is often measured as a mean, median, or mode.
At the core, Investment techniques assume that investments tend to return to their fundamental levels over time, this is known as central tendency

Question 98

Three approaches to forecasting capital market expectations

Answer 98

1. Formal Tools
2. Surveys
3. Judgements

Question 99

Formal Tools

Answer 99

Helps the analyst set capital market expectations. When applied to reputable data, formal tools provide forecasts replicable by other analysts. The formal tools we examine are statistical methods, discounted cash flow models, and risk premium models.

Question 100

Statistical methods

Answer 100

Involves sample statistics, shrinkage estimation, and time series estimation.

Question 101

Sample statistics

Answer 101

Sample statistics use well-known data, including means, variance, and correlation, to forecast future data

Question 102

Shrinkage estimate

Answer 102

A shrinkage estimate is a weighted average estimate based on history and some other projection. It can be applied to the historical estimate if the analyst believes simple historical results do not fully reflect expected future conditions

Question 103

Time Series Estimate

Answer 103

A time series estimate can also be used to make forecasts.
A time series estimate forecasts a variable using lagged values of the same variable and combines it with lagged values of other variables, which allows for incorporating dynamics (volatilities) into the forecasts.

Question 104

Discounted Cash Flow

Answer 104

Models that express the intrinsic value of an asset as the present value of other variables, which allows for incorporating dynamics (volatilities) into the forecasts

Question 105

Risk Premium

Answer 105

Also known of as buildup model. Risk premium approaches can be used for both fixed income and equity. The approach starts with a risk-free interest rate and then adds compensation for priced risk, or risks for which an investor would want to be compensated. Risk premium models include equilibrium models (e.g. the Capital Asset Pricing Model), a factor model and building block

Question 106

Surveys

Answer 106

The most useful ways to gauge consesus. In this method, a poll is taken of market experts, such as economists, and anaylsts, for their opinions regarding the economy or capital market

Question 107

Judgement ???

Answer 107

Can also be applied to project capital market expectation by using qualitative information based on experience.

Question 108

Discount Cash Flow Method (DCF)

Answer 108

is a financial model that estimates the value of an investment by discounting its expected future cash flows. This analysis is useful when there are known future cash flows, or when cash flows can be extimated reasonably accurately

Question 109

Risk Premium (Building Block) Approach

Answer 109

The building block approach starts with a risk-free rate and then adds compensation for addtional risks. The required return will include the one-period default-free rate, a term premium, a credit
premium, and a liquidity

Question 110

The short-term default-free rate

Answer 110

Matches the forecast horizon and Is calculated from the most liquid instructment

Question 111

Term Premium

Answer 111

The rates implied from the spot yleld curve gives us useful information about the term premium, the real term premium cannot be derived from the yield curve alone

Question 112

Credit Premium

Answer 112

Compensates for the expected level of losses and for the rixk of default loses, both of which are components of the credit spread

Question 113

Liquidity Premium

Answer 113

Liquidity tends to be the highest at the earliest stages of a bond’s life, typically during the first few weeks only. Securities with the highest liquidity are the newest sovereign bond issyesm current coupon mortagage-backe security’s, and some high quality corporate bonds

Question 114

Question:

An investor has a bond portfolio with a yield to maturity (YTM) of 4 and a modified duration of 5. The investor expects to hold on to the bond portfolio for at least the next six years but expects that bond yields will gradually rise over the investment horizon by a total of 100 bps. Determine whether the investor will realize a higher or lower overall yield than the initial YTM

Answer 114

The investor will realize a gain. The portfolio’s Macaulay duration is 5.2 (= 5 × 1.04).
Given that the investor’s investment horizon of six years is longer than the Macaulay duration, a rise in bond yields will result in a return that is higher than the YTM because the increase in reinvestment yield will outweigh the fall in the bond price.

Question 115

Signs that an emerging market is more susceptible to risk include:

Answer 115

• Wealth concentration
• Greater dominance of cyclical industries, including commodities and less pricing power
• Restriction on capital flows and trade; currency restriction
• Inadequate fiscal and monetary policies
• Poor workforce education and infrastructure and weak technological advancement
• Large amounts of foreign borrowing in foreign currencies
• Less developed and smaller financial market
• Exposure to volatile capital flows

Question 116

Deficit-to-GDP ratio

Answer 116

Used by most analyst to gauge fiscal policy

Question 117

Real Growth Rate

Answer 117

A measure of a country’s economic growth over time, adjusted for inflation or deflation. It’s calculated by comparing the real GDP from one period to the next, and is expressed as a percentage change.
To compensate for the higher risk in these countries, investors should expect a real growth rate of at least 4%

Question 118

Current Account Deficit

Answer 118

Occurs when a country imports more goods and services than it exports, resulting in more money being sent abroad than received. A current deficit exceeding 4% of GDP has been a warning sign of potential difficulty

Question 119

Foreign debt levels

Answer 119

Also known as external debt, refer to the total amount of money a country, corporation, or household owes to lenders in other countries. This includes money owed to governments, private lenders, and international organizations like the World Bank and the International Monetary Fund (IMF). Foreign debt levels greater than 50% of GDP indicate that the country may be overleveraged.

Question 120

Debt Levels

Answer 120

A measure of the total amount of debt that is outstanding, and is a basic macroeconomic variable. Debt is used to finance a variety of things, including government spending, businesses, and household consumption.
Debt levels greater than 200% of the current account receipts also indicate high risk

Question 121

Foreign exchange reserves

Answer 121

Assets held by a country’s central bank or monetary authority that are denominated in foreign currencies and used to support the country’s economy. They can include cash, bonds, gold, silver, and other assets.
Foreign exchange reserves relative to short-term debt is important because many emerging country loans must paid back in a foreign currency. Foreign exchange reserves less than 100% of short-term debt is a sign of trouble (greater than 200% is considered strong).

Question 122

Question:

An analyst is evaluating an emerging market for potential investment. She notices that the country’s current account deficit has been growing. Is this a sign of increasing risk? if so, why?

Answer 122

When exports are less than imports, a current account deficit usually results. This can
be problematic because the deficit must be financed through external borrowing. If the emerging country becomes overleveraged, it may not be able to pay back its foreign debt. A financial crisis may ensue where foreign investors quickly withdraw their capital. These financial crises are accompanied by currency devaluations and declines
in emerging market asset values.

Question 123

DCF Models

Answer 123

A tool for setting capital market expectations , These models say that the intrinsic value of an asset is the present value of future cash flows,The advantage of these models is their correct emphasis on the future cash flows of an asset and the ability to back out a required return. The models are most suitable for long-term valuation

Question 124

Grinold-Kromer Model

Answer 124

States that the expected return of a stock is its dividend yield, plus the inflation rate, plus the real earnings growth rate, minus the change in stock outstanding, plus changes in the P/E ratio.

E(Re) ≈ D/P + (%ΔE − %ΔS) + %ΔP/E)
where:
E(Re) = expected equity return
D/P = dividend yield
%ΔE = expected percentage change in total earnings
%ΔS = expected percentage change in shares outstanding (share repurchases)
%ΔP/E = expected percentage change in the P/E ratio

Question 125

Expected Cash Flow Return (income returns)

Answer 125

D/P – %ΔS = income return
D/P is the current yield as seen in the constant growth dividend discount model. It is
the expected dividend expressed as a percentage of the current price. The Grinold Kroner model goes a step further in expressing the expected current yield by
considering any repurchases or new issues of stock.

Question 126

expected nominal earnings growth

Answer 126

is the real growth in earnings plus expected inflation: expected nominal earnings growth return = %ΔE

Question 127

expected repricing return

Answer 127

captured by the expected change in the P/E ratio expected repricing return
= %Δ(P/E)

Question 128

It is helpful to view the Grinold Kroner model as the sum of the …

Answer 128

1.) expected cash flow return - dividend yield - increade in shares outstanding
2.) expected nominal earnings growth rate = real earning growth + inflation
3..) Expected repricing return P/E ratio
E(Re) ≈ (D/P − %ΔS) + (%ΔE) + (%ΔP/E)

Question 129

Single Terhaar Model

Answer 129

Based on two versions of the international capital asset pricing model (CAPM): one in which global asset markets are fully intergrated, and another in which markets are fully segmented.

The model then looks at the expectations of
actual segmentation/integration and takes a weighted average of the two assumptions to
calculate returns. The Singer-Terhaar approach begins with the CAPM:
Ri = Rf + βi,M (RM – Rf
), or alternatively RPi = βi,M × RPM
where:
Ri = expected return on asset i
Rf = risk-free rate of return
βi,M = sensitivity (systematic risk) of asset i returns to the global investable market
RM = expected return on the global investable market
RPi = the asset’s risk premium
RPM = the market’s risk premium

Question 130

Real Estate

Answer 130

Generally immobile and illiquid, and each property is part of a heterogeneous group with its unique characteristics.

Question 131

Real Estate Cycles

Answer 131

As a general asset class, real estate values are subject to business cycle movements, but they also drive business cycles. Given that supply is fixed at any given point in time, property values exhibit cyclicality, and demand will be strongly influenced by the quality and type of property available.

Question 132

When looking at real estate and business cycles, we observe the following characteristics:

Answer 132

• Boom: Increased demand will drive up property values and lease rates, which induces
  construction activity. This higher activity translates to stronger economic activity.
• Bust: Falling demand leads to overcapacity and overbuilding, driving values and lease rates down. Because leases lock in tenants for longer terms and moving costs are high, excess supply can’t be quickly absorbed.

Question 133

Capitalization Rates (or cap rate)

Answer 133

A commercial real estate property’s earnings
yields, and is calculated by dividing current net operating income (NOI) by the property
value.

Question 134

Net Operating Income (NOI)

Answer 134

Net operating income (NOI) shows the profitability of income-generating real estate investments. NOI includes all revenue from the property, minus necessary operating expenses.

Question 135

When an infinite time period is assumed, the cap rate can be calculate as:

Answer 135

cap rate = E(Rre) – NOI growth rate
E(Rre) = Cap rate + NOI growth rate
During stable periods, the long-run NOI growth rate should be close to GDP growth. If an investor has a finite time period, the formula changes by subtracting from expected return the change in the cap rate:
E(Rre) = cap rate + NOI growth rate – %Δcap rate

Question 136

Risk Premiums on Real Estate

Answer 136

Real estate assets require several risk premiums to compensate for their higher risk. These include a term premium for holding long-ter assets, a credit premium to compensate for the risk of tenant nonpayment, and an equity risk Premium above corporate bond returns for the fluctuation in real estate values, leases, and vancancies. Overall the combined risk Premium is higher than that of corporate bonds but lower than equities

Question 137

Liquidity risk

Answer 137

For publicly traded real estate, including REIT’s the liquidity risk is the risk that the asset cannot be sold quickly at a reasonable price. for real estate is reflects an inability to sell the asset except at periodic times. Liquidity Premium is considered to be between 2% and 4% for commercial real estate

Question 138

Residential Real Estate Returns

Answer 138

Account for 75% of global values. Overall it outperforms equities on an inflation-adjusted basis with lower volatility

Question 139

Question:

List two adjustments that analysts must make to the risk premiums calculated using equilibrium models:

Answer 139

Once an analyst estimates the risk premiums using equilibrium models, the analyst should
(1) remove the impact of smoothing from the data, and (2) adjust for illiquidity using a liquidity premium

Question 140

Discuss how cap rates are related to vacancy rates and the availability of debt financing

Answer 140

Cap rates are positively related to changes in interest rates and vacancy rate. They are inversely related to the availability of credit and the availability of debt financing

Question 141

Currencies

Answer 141

Units of account in which prices are quoted

Question 142

Exchange rates

Answer 142

Are determined by factors influence by trading, governments, financial systems, and geographies, as well as by laws, regulations, and customs of country

Question 143

Trade flows

Answer 143

The movement of goods and services between countries, firms, or people. It can also refer to the direction and components of imports and exports. Trade flows are important to globalization, and they affect the global allocation of capital and how shocks affect the world. They can also be linked to land use, which can impact global land-use changes.

Question 144

Purchasing power parity (PPP)

Answer 144

Implies that the prices of goods and services in different countries should reflect changes in exchange rate. As a result, the expected exchange rate movement should follow the expected inflation rate differentials. Furthermore, the expected change in real exchange rates should be zero, if real exchange rates are the ratio of price levels converted through a common exchange rate.

Question 145

Current Account and Exchange Rates

Answer 145

When restrictions are place on capital flows, exchange rate sensitivity tesnd to increase relative to the current account (trade) balance. Current account balances will have the largest influence on exchange rates when they are persistent and sustained. However, it is not the size of the current
account balance that matters as much as the length of the imbalance.

Question 146

Structural imbalances in the current account can exist from

Answer 146

1.) fiscal imbalances that persist over time
2.) demographics and trade preferences that impact saving decisions
3.) how abundant or scare resources are
4.) Availability (or lack) of viable investment opportunities
5.) The terms of trade

Question 147

Capital Mobility

Answer 147

The expected percentage change in the exchange rate can be computed as the difference between nominal short-term interest rates the the risk premiums of the domestic portfolio over the foreign portfolio

Question 148

Three phases of the response to stonger investment opportunities:

Answer 148

1. exchanged rate will initially significantly appreciate
2. following an extended level of stronger exchange rate in the intermediate term, investors will start to expect a reversal
3. the exchange rate in the long run will tend to start reverting once the investment opportunities have been realized

Question 149

Uncovered interest rates parity (UIP)

Answer 149

States that exchange rate changes should equal difference in nominal interest rates. UIP Implies that in the previous equation, only the interest rate differentials matters and not the premium differentials.

Question 150

Hot Money

Answer 150

capital which is frequently transferred between financial institutions in an attempt to maximize interest or capital gain.

Question 151

Assume that Japanese inflation is projected to be a cumulative 8.2% over the next five years, while U.S. inflation is 13.2% over the same period. U.S. inflation is thus projected to be 5% higher. Stock prices have just started to rise and will continue to do so for some time. Explain which asset class should an investor in Japanese assets favor:

Answer 151

The PPP relationship states that countries with high inflation will see their currency depreciate, so the manager should invest in Japan. Within Japan, the investor should invest in stocks because stock prices have just started to rise and will continue to do so
for some time. Bond yields will soon rise and their prices will fall as the economy
expands.

Question 152

Variance-covariance (VCV) matrix

Answer 152

a square matrix that contains the variances and covariances of a set of variables. It’s also known as a covariance matrix or dispersion matrix.
Here are some key features of a variance covariance matrix:
* Symmetric: The covariance between X and Y is the same as the covariance between Y and X.
* Diagonal elements: Contain the variances of the variables.
* Off-diagonal elements: Contain the covariances between all possible pairs of variables.
* Covariance: The covariance between two variables can be positive, negative, or zero. A positive covariance indicates a positive relationship, while a negative covariance indicates a negative relationship. A zero covariance indicates that the two elements do not vary together.
The variance covariance matrix is used in probability theory and statistics to generalize the notion of variance to multiple dimensions

Question 153

Heteroskedasticity (ARCH) models

Answer 153

A statistical model used to analyze and forecast the volatility of time series data. It’s often used in the financial world to estimate risk and model volatility in stock and investment markets. ARCH models can be used for portfiolios with multiple assets in VCV matrix estimations The si

Question 154

Methods for Volatility Forecasting

Answer 154

• Historical volatility: This method analyzes past price movements and volatility patterns to predict future volatility. A common approach is to calculate the standard deviation of past returns, such as a stock’s daily return over the last 30 days.
• Implied volatility: This method is based on option prices and reflects the market’s expectations of future volatility. A high implied volatility results in a higher option price.
• GARCH models: Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models are econometric models that are commonly used for volatility forecasting.
• Machine learning and artificial intelligence: These advanced techniques have become popular for volatility forecasting.
• Functional time series forecasting: This method predicts the next-period intraday volatility curve by fully exploiting intraday information.
  *NoVaS method: This model-free approach can be built from an ARCH model

Question 155

Volatility clustering

Answer 155

Assets returns generally show periods of high and low volatilities, leading to volatility clustering. These volatilities can be addressed through autoregressive conditional heteroskedasticity (ARCH) models.

Question 156

Discounted Cash Flow (DCF) Models:

Answer 156

CF(v)t(1+r)(^)t
* Equity markets
* Gordon (constant) growth model E(Re)=D1/P0+g
* Grinold-Kroner model: E(Re)≈D/P-ΔS+i+g+ΔPE
* Fixed-income markets - YTM often used as discount rate

Question 157

Risk Premium

Answer 157

The investment return an asset is expected to yield in excess of the risk-free rate of return. An asset’s risk premium is a form of compensation for investors. It represents payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset.

Question 158

Risk Premium Approaches

Answer 158

can be used for both fixed income and equity. The approach starts with a risk-free interest rate and then adds compensation for priced risks, or risks for which an investor would want to be compensated. Risk premium models include equilibrium models (e.g., the Capital asset Pricing Model), a factor model, and a building block.

Question 159

Surveys

Answer 159

Capital market expectations can also be formed using surveys, which can be the most useful way to gauge consensus.

In this method, a poll is taken of market experts, such as
economists and analysts, for their opinions regarding the economy or capital market. For example, the U.S. Federal Reserve Bank of Philadelphia conducts an ongoing survey regarding the U.S. consumer price index and GD