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CFA Level III > Economics > Flashcards

Economics Flashcards

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1
Q

CMA Challenges

A
  • Data is reported with a lag and subject to revision
  • Data is subject to biases and errors
    • transcription errors
    • survivorship bias
    • smoothed (appraised) data estimates (risk is understated)
  • Economic conditions change
    • regime change leading to nonstationary issues
  • Analyst bias in selective data mining or selection of time periods to examine.
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2
Q

Statistical Tools

A

Definition: Using historical data to develop statistics.

  • Arith is used for single periods, geo for multiple
  • Applying shrinkage (combining historically with model estimates)
  • Using time series models to estimate variance
  • Using multifactor models
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3
Q

Time Series Variance Formula

A

Variance2 = weight(std past2) + weight(residual error2)

Reminder to take the square root

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4
Q

Discounted Cash Flow Models

Advantages/Disadvantages

A

Advantages

  1. Based on future cash flows
  2. Ability to back out a required return

Disadvantages

  1. Doesn’t account for current market
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5
Q

Applying GGM to entire markets

A

Growth: nominal growth in GDP (real GDP + inflation)

Excess Corporate Growth: Adjusting for differences in GDP and equity index

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6
Q

GK Expected Income Return

A

(D1 / P0) - ▲S

▲S = % change in shares outstanding

Repurchase increases cash flows to investors and expected return

Issuance decreases both

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7
Q

Grinold and Kroner Model (GK)

A

r = (D1 / P0) - ▲S + i + g + ▲(P/E)

OR

r = exp(income return) + exp(nominal earnings) + exp(repricing)

  • exp(income return) = (D1 / P0) - ▲S
  • exp(nominal earnings) = i + g
  • exp(repricing) = ▲(P/E)
    • ▲S =% change in shares outstanding
      • ▲(P/E) = % change in the P/E ratio
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8
Q

Financial Equilibrium Approach

A

Estimating the equity risk premium using;

  • Corrrelation
  • Std
  • Share ratio

If market is fully segmented, diversification is impossible

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9
Q

Financial Equilibrium Steps

Equity Risk Premium

A

Step 1: Equity premium integrated = (cor)(std)(sharpe)
Equity premium segmented = (std)(sharpe)

*Make sure to add any illiquid premiums

  • *Step 2:** Take the weighted average of integrated/segmented
  • *Step 3:** Add the risk-free rate to both intregrated/segmented
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10
Q

Financial Equilibrium Formula

Beta and Covariance

A

Beta

(Cor)(stdi) / stdm

Covariance

(B1)(B2)(stdm)2

Note: std is whole numbers

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11
Q

Expected Current Yield

Expected Capital Gains Yield

Total Expected Return

A

Expected Current Yield (income) = dividend yield + repurchase yield

Expected Capital Gains Yield = real growth + inflation + repricing

Total expected return = Current Yield + Capital Gains Yield

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12
Q

Inventory and Business Cycles

A

Inventory Cycle

Last 2-4 years
Measued with inventory to sales ratio (I/S)

If I/S is going up due to I GOOD SIGN

If I/S is going up due to S BAD SIGN

Business Cycle

9-11 years
5 phases

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13
Q

Business Cycle Phases

A

Inflation Interest Rates Confidence & Stocks

Initial Recovery Falling Falling Rising

Early Upswing Falling Rising Rising

Late Upswing Rising Rising Peak

Slowdown Rising Peak Falling

Recession Peak Falling Falling then Rising

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14
Q

Components of GDP

A

GDP = C + I + G + Net exports

C = Consumer spending (stable)

I = investment (volatile)

G = Government spending

Net exports = X - M

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15
Q

Taylor Rule

A

Prescribed central bank policy rate

real policy rate + inflation + .5(expInflation - target inflation) + .5(expGDP - trendGDP)

Neutral rate = real policy rate + inflation

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16
Q

Inflation and Asset Class Attractiveness

A

Inflation(exp) Cash Bonds RE Equity

At or below Neutral Neutral Neutral +

Above exp + - + -

Deflation - + - -

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17
Q

Yield Curve/Economy with Government Policies

A
  • *Monetary/Fiscal Policy Effects**
  • *Yield Curve Economy**

E / E Steep Grow
E / R Steep Uncertain
R / E Flat Uncertain
R/R Inverted Contract

E = Expansion

R = Restrictive

18
Q

Economic Growth Trends

A

Two main components:

  1. Changes in employment levels
  • Population growth
  • Rate of labor force participation
  1. Changes in productivity
  • Spending on new capital inputs
  • Total factor productivity growth
19
Q

Structural Gov. Policies for L/T Growth

A
  1. Sound fiscal policy
  2. Sound tax policies
  3. minimal government interfrence with free markets
  4. Facilitate competition
  5. Develop infrastructure and human capital
20
Q

Ability to Service Debt Signs

EM Warning Sign

A

Ability to Service Debt Lower If:

  1. Current account deficit > 4% of GDP
  2. Foreign Debt/GDP > 50%
  3. Foreign currency reserves/ST debt < 100%
  4. Government deficit/GDP ratio > 4%

EM Warning Sign:

  • Growth < 4%
21
Q

Cobb-Douglas

A

Real GDP = TFP + weight(Capital) + weight(Labor)

Slow Residual (TFP) = Real GDP - weight(Capital) - weight(Labor)

*Constant returns to scale

*subject to diminishing returns

22
Q

Total Factor Productivity (TFP) Increase With……

A

Increases over time with;

  • Improving technology
  • Discovering natural resources
  • Fewer trade restrictions
  • Fewer restrictions on capital flows and labor mobility
23
Q

DDM for Developed and Less Devoloped Economies

A

Developed

Stable dividends, growth, and risk
Should use GGM

Less Developed

Economic data less available and not reliable
Corporate cash/dividend growth less direct
Significant changes in annual growth
Uses H-Model (2 stage)

24
Q

GGM Formula

A

P0 = D1 / r - g

Rearranged for required return;

r = (D1 / P0) + g

25
Q

H Model Formula

A

D0 * [(1 + gL) + H(gS - gL)]

r - gL

Use the real discount rate;

  • inflation rates flucuate so easier to compare
  • More stable
  • r increasing means P decreases
26
Q

Justified P/E Formula

A

Take H Model Value / Forecasted EPS

27
Q

EPS Top Down vs Bottom Up Differences

A
  1. Top down based on historical relationships
    1. Slow to reflect changes
  2. Bottom up are overly emotional
    1. Too optimisic in expansion
    2. too pessimistic in recession
28
Q

Fed Model

A

Definition: Yield on S&P should be same as l/t treasuries

Formula: S&P EY / 10-year treasury
S&P EY = expected operating earnings / current price of S&P

Interpretation: S&P yield > treasury = equities are undervalued

29
Q

Fed Model Drawbacks and Inflation

A

Drawbacks:

  • Ingores equity risk premium
  • Ingores earnings growth

Inflation (also a drawback):

  • EY is real
  • Treasury yield is nominal
30
Q

Yardeni Model

A

Definition: actual EY vs theoretical (fair value) EY

Fair Value EY: E1 / P0 = YB - d(LTEG)

Actual EY: E1 / P0 OR stated

Note: Discount rate is the A-rated corporate bond yield

Example

YB= 6.49, LTEG = 11.95, d = 0.05, S&P EY = 5.5%

0.0648 - 0.05(0.1195) = 5.89. Higher than 5.5 so its overvalued

31
Q

Yardeni Model Interpretation & Model Inputs

A

If actual EY < fair value: Actual EY is too low (stocks are too high)

If actual EY > fair value: Actual EY is too high (stocks are too low)

YB - Yield on A-rated corporate bonds
d = weighting factor (typically 0.1)
LTEG = 5 year growth forecast

32
Q

Yardeni Model Equity Value

A

V0 = E1 / YB - d(LTEG)

If P0 > V0 —– The market is overvalued

Example
YB = 6.32, LTEG = 11.5%, d = 0.10
When would equities be overvalued?

0.0632 - 0.10(0.115) = 0.0515
1/0.0517 = 19.3, So Anything over 19.3 is overvalued

33
Q

Yardeni Model Pros/Cons

A

Pros

Incorporates equity risk by using corporate BY

Cons

Equity risk premiums exceed corporate BY
Earnings estimate can be wrong
Assumes the discount rate is constant

34
Q

10-Year Moving Avg P/E Ratio

A

Definition: compares current P/E to a moving average of P/E

Notes: moving average IS adjusted to account for inflation

Drawbacks:

  • Accounting changes can cause issues
  • Long periods of high or low P/E can persist
35
Q

Tobin’s Q

A

Tobin’s Q:

Compares the current market value of company to replacement cost of assets

Q = MV of debt + equity
replacement cost

If Q > 1, equity is overvalued
If Q < 1, equity is undervalued

MUST be compared to an equilibrium value (otherwise you dont know)

36
Q

Equity Q

A

Equity Q:

Compares the current market value of equity to replacement cost

Q = MV of equity
replacement cost of assets - liabilities

If Q > 1, equity is overvalued
If Q < 1, equity is undervalued

37
Q

Monetary/Fiscal Policy

A

Montetary

Money supply. Increasing stimulates economy

Fiscal

Government spending or lowering taxes stimulates economy

38
Q

Bond-yield-plus-risk-premium method

A

long-term government bond + the equity risk premium

39
Q

Psychological Traps

A
  1. Prudence Trap: over conservative
  2. Recallability Trap: Easiert to remember(event in 2008)
  3. Ex post risk a biased measure of ex ante risk (Survey)

From Behavioral Finance:

  1. Achoring Trap
  2. Status Quo Trap
  3. Confirming Evidence
  4. Overconfidence Trap
40
Q

From Questions

A

Output gap: difference between actual GDP and the l/t trend
Increase with inflation lowers

Permanent Income Hypthesis: spending behavior based on l/t income expectations
(s/t events will not affect spending habits)

CFA Level III (13 decks)

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