Capital Markets Expectations

Question 1

What is the Grinold-Kroner model equation?

Answer 1

(Dividend yield minus repurchase yield) + (Real growth in earnings plus expected inflation) + Expected change in price to earnings ratio

Question 2

If bond yields are predicted to rise, and the investors time horizon is less than the bond Macaulay duration, what will be the gain compared to YTM?

Answer 2

The investor will realise a gain below the YTM

Question 3

If bond yields are predicted to rise, and the investors time horizon is more than the bond Macaulay duration, what will be the gain compared to YTM?

Answer 3

The investor will realise a gain greater than the YTM

Question 4

How do you calculate Macaulay duration from the modified duration and the yield?

Answer 4

Modified duration x (1 + yield)

Question 5

What is the Taylor rule equation?

Answer 5

Real rate: Neutral rate + 0.5 × (GDP growth forecast – GDP growth trend) + 0.5 × (Inflation forecast – Inflation target)

Nominal rate: Neutral rate + Inflation forecast + 0.5 × (GDP growth forecast – GDP growth trend) + 0.5 × (Inflation forecast – Inflation target)

Question 6

What are the key signs of emerging market risk?

Answer 6

Fiscal deficit greater than 4%
Debt greater than 70%
Current account deficit greater than 4%
Foreign exchange reserves 100% of short-term debt

Question 7

What is hot money flows and why is it a problem?

Answer 7

Vigorous flows of capital in response to interest rate differentials are often referred to as hot moneyflows. Firstly, it limits the central bank’s ability to run an effective monetary policy. Second, A flood of readily available short-term financing may encourage firms to fund longer-term needs with short-term money, setting the stage for a crisis when the financing dries up. Third, the nearly inevitable overshooting of the exchange rate is likely to disrupt non-financial businesses.

Question 8

How can a country counteract hot money inflows?

Answer 8

Intervene in the currency market to offset the exchange rate impact of the flows by buying foreign currency. May also attempt to sterilize the impact on domestic liquidity by selling government securities to limit the growth of bank reserves or maintain a target level of interest rates.

Question 9

How can a country counteract hot money outflows?

Answer 9

Intervene in the currency market to offset the exchange rate impact of the flows by selling foreign currency. May also attempt to sterilize the impact on domestic liquidity by buying government securities to limit the growth of bank reserves or maintain a target level of interest rates.

Question 10

What is the Singer–Terhaar model equation?

Answer 10

Full integration = Correlation x Vol x Sharpe
Full segmentation = Vol x Sharpe
Mixed = Wi x FullIntegration + Ws x FullIntegration

Add the risk free rate to get the returns

Question 11

What are the findings from the Singer-Terhaar model?

Answer 11

An increase in integration will reduce the risk of the equity market, thus reducing required returns. The reduction in required returns will increase equity prices and result in higher returns over the period of increased integration.

Question 12

What is the most favourable time to allocate to equity?

Answer 12

The most favourable phases when considering equity returns are initial recovery and early upswing

Question 13

How do assets behave in the initial recovery phase?

Answer 13

Short-term interest rates and bond yields are low. Bond yields are likely to bottom. Stock markets may rise strongly. Cyclical/ riskier assets such as small stocks, high-yield bonds, and emerging mar- ket securities perform well.

Question 14

How do assets behave in the early expansion phase?

Answer 14

Short rates are moving up. Longer-maturity bond yields are stable or rising slightly. Stocks are trending up.

Question 15

How do assets behave in the late expansion phase?

Answer 15

Interest rates rise, and the yield curve flattens. Stock markets often rise but may be volatile. Cyclical assets may underperform while inflation hedges outperform.

Question 16

How do assets behave in the slowdown phase?

Answer 16

Short-term interest rates are at or nearing a peak. Government bond yields peak and may then decline sharply. The yield curve may invert. Credit spreads widen, especially for weaker credits. Stocks may fall. Interest-sensitive stocks and “quality” stocks with stable earnings perform best.

Question 17

How do assets behave in the contraction phase?

Answer 17

Interest rates and bond yields drop. The yield curve steep- ens. The stock market drops initially but usually starts to rise well before the recovery emerges. Credit spreads widen and remain elevated until clear signs of a cycle trough emerge.

Question 18

How do rates, policy and yield curve behave in the initial recovery phase?

Answer 18

Policy is stimulative, maybe moving to tightening. Money market rates are low/bottoming with increases expected in shorter horizons. Yield curve is steep, but short rates begin to rise first.

Question 19

How do rates, policy and yield curve behave in the early expansion phase?

Answer 19

Policy has withdrawn stimulus, money markets are moving up with pac accelerating. Yields rising. Possibly stable at longest maturities. Curve is flattening.

Question 20

How do rates, policy and yield curve behave in the late expansion phase?

Answer 20

Policy is becoming restrictive, money markets are above average and rising. Bond yields are rising but pace slowing, and curve is flattening.

Question 21

How do rates, policy and yield curve behave in the slowdown phase?

Answer 21

Policy is tight, tax revenues may surge as accumulated capital gains are realised, money markets are peaking, bond yields are peaking and may decline sharply and curve is inverted.

Question 22

How do rates, policy and yield curve behave in the contraction phase?

Answer 22

Progressively more stimulative, money markets declining, bond yields declining and curve steepening.

Question 23

What is the effect of tight fiscal policy and tight monetary policy?

Answer 23

Low Real Rates + Low Expected Inflation =
Low Nominal Rates

Question 24

What is the effect of tight fiscal policy and loose monetary policy?

Answer 24

Low Real Rates + High Expected Inflation =
Mid Nominal Rates

Question 25

What is the effect of loose fiscal policy and loose monetary policy?

Answer 25

High Real Rates + High Expected Inflation =
High Nominal Rates

Question 26

What is the effect of loose fiscal policy and tight monetary policy?

Answer 26

High Real Rates + Low Expected Inflation =
Mid Nominal Rates

Question 27

What are the signs of an initial recovery phase?

Answer 27

Business confidence rises, stimulative policies still in place, negative output gap is large, inflation typically decelerating, rising housing and consumer durables spending

Question 28

What are the signs of an early expansion phase?

Answer 28

Gaining some momentum and unemployment starts to fall, but the output gap remains negative, consumers borrow and spend, businesses step up production and investment, profits typically risk, demand for housing and consumer durables is strong

Question 29

What are the signs of a late expansion phase?

Answer 29

Output gap has closed and the economy is increasingly in danger of overheating, boom mentality prevails, unemployment is low, profits are strong, wages and inflation are rising, capacity pressures boost investment spending, debt coverage ratios deteriorate as balance sheets expend and interest rates rise, central bank may aim for a “soft landing”, and will limit growth of money supply, investor nervousness increases risk during this period

Question 30

What are the signs of an slowdown phase?

Answer 30

Economy is slowing and approaching the eventual peak, usually in response to rising interest rates, fewer investment projects and higher accumulated debt, business confidence wavers, inflation often continues to rise as firms raise prices

Question 31

What are the signs of a contraction phase?

Answer 31

Recessions typically last 12 to 18 months. Investment spending leads the contraction, profits drop and firms cut production sharply, central bank eases monetary policy, major bankruptcies, incidents of uncovered fraud, exposure of aggressive accounting practices or financial crisis, unemployment rise quickly

Question 32

What is anchoring bias?

Answer 32

Tendency to give disproportionate weight to the first information received or first number envisioned, which is then adjusted.

Question 33

What is status quo bias?

Answer 33

Tendency for forecasts to perpetuate recent observations—that is, to avoid making changes and preserve the status quo, and/or to accept a default option.

Question 34

What is confirmation bias?

Answer 34

Tendency to seek and overweight evidence or information that confirms one’s existing or preferred beliefs and to discount evidence that contradicts those beliefs.

Question 35

What is overconfidence bias?

Answer 35

Unwarranted confidence in one’s own intuitive reasoning, judgment, knowledge, and/or ability.

Question 36

What is availability bias?

Answer 36

Tendency to be overly influenced by events that have left a strong impression and/or for which it is easy to recall an example.

Question 37

What is prudence bias?

Answer 37

Tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting.