Reading 2

Question 1

Central Tendency

Answer 1

At their core, investment techniques assume that investments tend to return to their fundamental value over time.

Question 2

Approaches to forecasting capital market expectations

Answer 2

1. formal tool
2. surveys
3. judgements

Question 3

Shrinkage estimate

Answer 3

weighted average estimate based on history and some other projections

Question 4

Time series estimate

Answer 4

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 5

Modified Duration

Answer 5

Macaulay Duration / (1+YTM)

Question 6

Decline in bond yields given modified duration and YTM

Answer 6

If Macaulay duration (modified duration * YTM) is longer than the investment horizon, decline in bond yields will result in realized return higher than YTM because gain on the bond price will outweigh the decline in reinvestment yield

Question 7

Drivers of term premium

Answer 7

1. inflation uncertainty
2. recession hedge
3. supply and demand
4. business cycles

Question 8

Recession hedge as driver of term premium

Answer 8

When inflation is caused by strong AD, nominal bond returns are negatively correlated with growth, corresponding to low term premiums. When inflation is caused by aggregate supply, nominal bond returns are positively correlated with growth, corresponding to higher term premiums.

Question 9

Barbell strategy

Answer 9

take credit risk from shorter maturity bonds and duration risk from long maturities

Question 10

Fiscal policy guage

Answer 10

Deficit to GDP ratio
If more than 4%, indicates substantial credit risk

Question 11

Emerging market debt guage

Answer 11

Debt to GDP ratio of 70% to 80% - troublesome

Question 12

Current account deficit gauge

Answer 12

If current account deficit excees 4% of GDP - has been a warning sign of potential difficulty

Question 13

Foreign debt levels for judging EM

Answer 13

if more than 50% of GDP - overleveraged country; debt levels greater than 200% in general of the current account receipts also indicate high risk

Question 14

What are the 2 adjustments that analysts must make to the risk premiums calculated using equilibrium models?

Answer 14

once an analyst estimates the risk premiums using equilibrium models, the analyst should:
1. remove the impact of smoothing from the data

2. adjust for illiquidity using a liquidity premium

Question 15

Foreign exchange reserves for judging EM

Answer 15

If less than 100% of short term debt - sign of trouble; greater than 200% in general: strong

Question 16

Grinold-Kroner Model

Answer 16

Expected return of a stock is its dividend yield, plus inflation rate, plus real earnings growth rate, minus change in stock outstanding, plus change in PE ratio; also expected cash flow return + expected nominal earnings growth + expected repricing return

Question 17

Grinold-Kroner model: expected cash flow return

Answer 17

Dividend yield D/P (using expected dividend) minus % of share repurchases

Question 18

Grinold Kroner - expected nominal earnings growth

Answer 18

real growth in earnings + expected inflation (% change in E)

Question 19

Grinold-Kroner: expected repricing return

Answer 19

expected change in P/E ratio

Question 20

Equity risk premium

Answer 20

amount by which the equity return exceeds risk free rate

Question 21

List 2 adjustments that analysts must make to the risk premiums calculated using equity models

Answer 21

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

Question 22

What are the 3 methods of forecasting fixed income returns?

Answer 22

1. DCF
2. risk premium approach
3. Equilibrium model

Question 23

How does Macaulay duration and investment horizon work?

Answer 23

• If investment horizon is shorter than Macaulay duration, the capital gain/ loss impact will be more dominant than the reinvestment impact eg falling interest rates will result in higher realized return, rising interest rate will result in lower realized return
• if Investment horizon is longer than Macaulay duration, the reinvestment risk dominates, meaning that falling interest rates will result in lower realized return, while rising interest rates will result in higher realized return

Question 24

Downgrade Bias in Credit Premium

Answer 24

asymmetrical risk indicating that a downgrade is more likely than a credit improvement or an upgrade

Question 25

Risk premium approach

Answer 25

rf + term premium + liquidity premium + credi tpremium

Question 26

Discuss how cap rates are related to changes in interest rates and vacancy rates?

Answer 26

cap rates are inversely related to the availability of credit and the availability of debt financing

Question 27

What happens if Macaulay duration = investment horizon?

Answer 27

capital loss created by an increase in yields and the reinvestment effects (gains) will roughly offset, leaving the realized return approximately equal to the original yield to maturity. This relationship is exact if:
1. yield curve is flat
2. change in rates occurs immediately in a single step.

Question 28

Grinold Kroner Model

Answer 28