Section I.C. Global Capital Markets History and Valuation

Question 1

What does negative correlation between real rate and inflation rate mean?

Answer 1

means the nominal rate doesn’t fully compensate investors for
increased in inflation

Question 2

Based on assumptions (e.g., you expect
inflation, disinflation, or deflation), which would recommend to clients?

Answer 2

• reallocating between stocks and bonds
• shifting within sectors or asset classes
• timing decisions

Question 3

Has the US ever defaulted?

Answer 3

– 1779, 1790, 1798, 1862, 1933, 1971, and 1979

Many times, but Remember: the term default does not solely mean that a debtor did not pay, it more broadly means that a debtor did not pay per the debt’s original terms (i.e., as was promised).

Question 4

What is the Gold Standard?

Answer 4

Monetary system where the economic unit of trade (e.g., local currency) is
based on or linked to gold.

Three types of gold standard systems:

1. Exchange – fixed exchange rate to currency backed by gold
2. Bullion – bullion is traded on demand in exchange at fixed price for currency
3. Specie standard – gold coins are the primary unit of trade

No government today is actually on the gold standard. The U.S. stopped
following a strict form of the gold standard in 1933 and abandoned the entire concept in 1971.

Bretton Woods Agreement 1944:

The U.S. dollar essentially becomes the worlds primary reserve currency (near
the conclusion of World War II), but the dollar was still tied to gold at a new
fixed rate.

The U.S. moves completely away from any gold standard in 1971.

Question 5

What are ramifications, potential benefits and potential drawbacks of the Gold Standard?

Answer 5

Ramifications

Requiring gold reserves to back up or guarantee paper currency should, in theory, help manage inflation. Assuming that the amount of gold available is fixed, this can actually have a deflationary effect.

Potential Benefits

Stabilizes prices; can reduce uncertainty in trade; acts as a check and balance in keeping governments from creating units of their own currency at will; a system such as the gold standard can help prevent dishonest governments from manipulating economies and
financially systems.

Potential Drawbacks

Applying a gold standard system is not convenient, is not very flexible and may not be sufficiently scalable; can create large short-term swings in value and price; such a standard can also be manipulated or controlled through war and other means.

Correlation – the value of gold and the U.S. dollar typically have an inverse relationship (e.g., if the U.S. dollar rises then the price of gold falls in dollar terms).

Question 6

What is The Equity Premium?

Answer 6

Defined: the equity premium is the excess return of stocks over the risk-free return over a specific period of time.

Formula:

[(1 + equity return)/(1 + risk free return)] – 1

Example:

S&P 500 return = 10%; Risk-free return = 3%

10% - 3% = 7%

[(1 + .10)/(1 + .03)] – 1 = 6.80%

Question 7

What is PE10 Ratio (Shiller’s PE)?

Answer 7

also known as the “cyclically adjusted PE”
(CAPE); smoothes out fluctuations in earnings due to the business cycle; uses earnings per share figures adjusted for inflation and averaged over 10 years as the denominator

Question 8

What is the Q-Ratio?

Answer 8

• Defined: developed by James Tobin (Yale); a valuation model that says the actual value of all companies should be equal to the replacement cost of their assets

• Formula:

Q Ratio = Total Market Value of Firm/Total Asset Value

• Analysis:

Value < 1 implies the stock or market is undervalued
Example: $1.0t/$1.5t = .67

Value > 1 implies the stock or market is overvalued
Example: $1.5t/$1.0t = 1.5

Question 9

How have Emerging vs Developing Equities compared?

Answer 9

MSCI developed : 16.7
MSCI emerging: 11.9

Question 10

Other things equal, diversification is most
effective when…

Answer 10

Negative correlation among securities results in the greatest reduction of portfolio risk, which is the goal of
diversification.

Question 11

What are Correlation Effects?

Answer 11

• The amount of possible risk reduction through diversification depends on the correlation.

• The risk reduction potential increases as the correlation approaches -1.

– If ρ = +1.0, no risk reduction is possible.
– If ρ = 0, σP may be less than the standard
deviation of either component asset.
– If ρ = -1.0, a riskless hedge is possible.

Question 12

How do you reduce portfolio risk?

Answer 12

While standard deviation is a measure of
total (or overall) risk and a helpful metric to be sure; we’re actually looking for low
correlations to lower the overall “portfolio
risk” when considering adding any new
asset or investment to a portfolio.

Question 13

What are the Benefits from International Diversification?

Answer 13

• Correlations between countries suggest international diversification is beneficial, especially for active investors.
• Sharpe ratio of internationally diversified portfolio is higher than the U.S. alone.
• M^2 shows advantage of the world countries portfolio is 284 basis points.

Question 14

Are Benefits Preserved in Bear Markets?

Answer 14

• Correlations between countries may increase in a crisis.

• Roll’s model suggests a common factor
underlying the movement of stocks around the world.

• Prediction: Diversification only
protects against country-specific events.

• What happened in 1987? In 2008? In 2020?

Question 15

Recent Increase in Correlations

Answer 15

• Since the 1990’s there has been an increase in correlation in equity prices of many international developed markets.

• There is a fair amount of speculation as to why this has occurred and if correlations will remain at this level or
possibly move even higher.

• Possible reasons for increased correlations:

– Globalization (advances in technology, communication, etc.)

– Increased volatility and crises lead to higher correlations

– Increase in emerging market capitalization

Question 16

Equity Correlations Over Time

Answer 16

Point – correlations typically rise during major market corrections and times of crises

Question 17

Currency Hedging Equities

Answer 17

• Currency hedging international (e.g.,
non-U.S.) equity investments is not
typically necessary or helpful
– CIMA text, page 261

• U.S. investors may choose to invest in
American Depository Receipts (ADRs) to
gain exposure to international stocks
– CIMA text, page 266

• Investing in multi-national companies
does not typically offer the same
diversification benefits of investing in
other broader markets or regions
– CIMA text, page 268

• Currency hedging international (e.g.,
non-U.S.) bond investments may be
beneficial
– CIMA text, page 303

Question 18

Which bonds produced the most efficient risk to reward relationship as evidenced by its Sharpe ratio?

Answer 18

Intermediate-term bonds during a disinflationary period (1981-2009) and inflationary period (1951-2009).

Least efficient: long-term bonds during both inflationary and disinflationary period.

For roughly 30 years after WWII, inflation and rates rose. For last 30 years, inflation and rates have fallen.

Question 19

If we are in a deflationary environment, expecting inflation and interest rates to fall in the coming years, what recommendation would be appropriate for a client?

Answer 19

• increase bond allocation, increase duration and quality
• decrease equity allocation, decrease exposure to real assets

If inflation and rates will be falling due to inflation, you would want to own longer term bonds and fixed income instruments, including high quality sovereign debt, you would not want to own real assets which would likely fall in value due to deflation.

Question 20

Since 1955, treasury bond yields and earning yields on stocks were:

Answer 20

Positively correlated.

The earnings yield on stocks equals the expected rate of return on the stock market, which should be equal to the yield to maturity on treasury bonds plus a risk premium, which may change slowly over time.

Question 21

Which fixed income investments had the lowest historical correlation to the S&P index over the long-term?

Answer 21

Lowest: Intermediate / medium-term treasuries (0.02)

Highest: High Yield (0.56)

Train of thought: high yield bonds have higher correlation to stocks vs. aggregate bond index. An aggregate bond index has higher correlation to stocks compared to short and medium term U.S. treasuries.

Question 22

When does portfolio diversification best benefit the investor?

Answer 22

When portfolio holdings have negative correlations.

Investors typically benefit greatest when assets in a portfolio are highly negative correlated. The less correlation the better. Assets with high positive correlations offer little in terms of benefits from diversification. Assets with low positive correlations offer benefits from diversification but negative correlations are even better.

Question 23

What are true statements regarding equity market valuations over the last 20 years?

Answer 23

1) valuations of developed markets are approximately the same now as they were 20 years ago

2) valuations of emerging markets overall have declined over the last 20 years

Valuations are approximately the same for developed markets as they were 20 years ago despite having risen in the late 1990’s and subsequently fallen through the financial crises only to rebound since 2009. The spread between the valuations of emerging and developed markets was very narrow during the financial crises. The valuations of emerging markets have been considerably lower than that of developed markets for most of the last 20 years. Valuations of emerging markets have declined over the last 20 years by roughly 20%z

Question 24

What are true statements about international investing?

Answer 24

1) Investing in ADRs is typically an attractive way to invest in international companies

2) Hedging broadly diversified international equity positions is not typically a necessary strategy to manage currency risk.

Investing in ADRs is typically an attractive way to invest in international companies. Hedging broadly diversified international equity positions is not typically a necessary strategy to manage currency risk. Hedging broadly diversified international bond positions is typically considered a necessary strategy to manage risk. Investing in most multi-national companies does not offer strong international diversification benefits.

One reason that foreign diversification is less effective in more recent years is that the correlation between foreign and domestic stocks has increased markedly, so foreign diversification reduced risk less than it did in the past.

Question 25

What is true about the correlation of assets and the most recent financial crisis?

Answer 25

Correlations on most asset classes rose significantly, offering less protection agains price declines even for well diversified investors.

The correlations between most major asset classes rose significantly in the last financial crisis, offering less protection against price declines than had been expected by those investing in well diversified portfolio. That being said, not all correlations rose, and they certainly did not rise to 1.00.

Question 26

What is the least likely reason for correlations of stocks between developed counties to have risen since the 1990s?

Answer 26

Lower fees and trading costs

There is debate over the reason for the increase in correlations over the last 25 years. The rise of China and other emerging markets and the rapid increase in technology are commonly mentioned. Markets exhibiting higher volatility usually see rising correlations during these periods. All of these could influence correlations.

Question 27

What countries are considered as an emerging market?

Answer 27

BRIC

Brazil
Russia
India
China

S - South Africa

Question 28

What happens to Real Returns on treasury bonds during inflationary and deflationary periods,

Answer 28

Inflationary: expected to decline and even become negative
Deflationary: usually positive, but expected to decline