Section I.C. Global Capital Markets History and Valuation

Question 1

The Gold Standard

Answer 1

• 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 world’s 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 2

PE10 ratio / Shiller PE / CAPE

Answer 2

• Also known as the “cyclically adjusted PE (CAPE)”
• Smooths 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 3

Q ratio (Tobin’s Q)

Answer 3

• 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
• A value under 1 implies an undervalued equity while a ratio of greater than 1 implies that stock is overvalued
• Formula = total market value of firm / total asset value