optiix

Which of the following statistical tools adjusts historical estimates using a weighted average of the historical value and an analyst-determined value?

A) Multifactor model.

B) Shrinkage estimator.

C) Time series analysis.

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Shrinkage estimators are weighted averages of historical data and some other estimate, where the weights and other estimates are defined by the analyst. Shrinkage estimators reduce (shrink) the influence of historical outliers through the weighting process. This tool is most useful when the data set is so small that historical values are not reliable estimates of future parameters.

optiix

Bill Litner, CFA and Susan Cabell, CFA are composing an economic and financial newsletter for the employees of Terrific Tires, Inc. (TTI). In it, Litner and Cabell will publish their capital market expectations. The purpose of the newsletter is to help TTI’s employees make decisions in the management of their defined contribution pension plans. Litner and Cabell have subscribed to several sources of data to compose the forecasts that they intend to include in the newsletter. One data set consists of macroeconomic variables such as unemployment, interest rates, and output for various sectors of the economy and the entire economy (GDP). Litner and Cabell compute the correlations of the macroeconomic data with the returns of a select group of stocks. They use 10 years of weekly data to compute the correlations. After finding the economic variables that have the highest correlations with the stocks, they compose a model using those variables to predict the returns of the stocks. Litner and Cabell also perform a factor analysis of stocks FGI and VCC. Using a world index “S” and a world bond index “B” in a two-factor model, they compute the following estimated equations for the returns of FGI and VCC respectively:

RFGI = 1.4 × FS,FGI − 0.2 × FB,FGI + εFGI
RVCC = 0.8 × FS,VCC + 0.1 × FB,VCC + εVCC

The variance of the stock and bond factors are 0.04 and 0.007 respectively. The covariance of the two factors is 0.01. Litner and Cabell will use these results to forecast the covariance of the returns of FGI and VCC. Litner and Cabell intend to augment their capital market expectations models with data on consumer and business spending. They have not used this data before, but they feel this data can help in the prediction of changes in the business cycle. In order to have more focus, they want to determine which of the two measures might be more important. They think it would be better to focus on business spending for several reasons. Litner says that business spending is more volatile than consumer spending. Cabell says that business spending is also the larger of the two. Inflation is another variable that Litner and Cabell consider for their models. They discuss the relationship between inflation and asset returns. Cabell suggests that inflation can be used with GDP growth for predicting the Fed’s next move on interest rates. They look at their macroeconomic data to see how the current GDP growth compares to the trend GDP growth and the current inflation compares to the Fed’s announced inflation target. They find that the current GDP growth is higher than the trend GDP growth. Inflation is lower than the announced target from the central bank. Litner and Cabell employ the Taylor Rule for predicting a change, if any, in the central bank’s target for the short-term interest rate. In considering how to address interest rates in their newsletter, Litner and Cabell also look at the shape of the yield curve, which is currently flat. Litner and Cabell discuss the conditions that could give a flat yield curve. Litner says that such a curve is indicative of restrictive monetary policy. Cabell says that a flat yield curve is indicative of expansionary fiscal policy. Litner and Cabell discuss the use of economic indicators that are available for governments and international organizations, and they agree that the availability of the indicators is one of the advantages of using such indicators. Litner says another advantage of such indicators is that economic variables and asset returns tend to have fairly stable relationships with the indicators that are fairly consistent over time. Cabell adds that another advantage is that the economic indicators can be readily adapted for specific purposes. Having assessed their available resources and strategy, Litner and Cabell begin composing their newsletter for TTI employees. In composing their model using the macroeconomic data, the approach of Litner and Cabell:

A) may have problems because they are using data from too early a time only.

B) may have problems because they are using data from too early a time and they are assuming correlation is causation.

C) is justified based upon the length of the data set but not by its using historical correlations.

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There is likely to be a regime change over a 10-year period, and it is not recommended that estimates for composing expectations be based upon data going back such a long period. Also, building a model based only on historical correlations is not recommended because correlation is not causation. (Study Session 6, LOS 18.b)

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Using the results of the estimated factor models, the forecasted covariance of FGI and VCC would be closest to:

A) 0.0445.

B) 0.0244.

C) 0.0488.

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Cov(i,j) = βi,1βj,1σ2F1 + βi,2βj,2σ2F2 + (βi,1βj,2 + βi,2βj,1)Cov(F1,F2)
Cov(i,j) = (1.4 × 0.8 × 0.04) − (0.2 × 0.1 × 0.007) + [(1.4 × 0.1) + (-0.2 × 0.8)](0.01) = 0.04446. (Study Session 6, LOS 18.c)

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With respect to their comments concerning the relative volatility and size of business spending with respect to consumer spending Litner:

A) is correct and Cabell is incorrect.

B) and Cabell are both incorrect.

C) is incorrect and Cabell is correct.

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Litner is correct in that business spending is more volatile, but consumer spending is many times larger than business spending; therefore, Cabell is incorrect. (Study Session 6, LOS 18.e)

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With respect to how the central bank will change its target for the short-term interest rate, using the given information concerning GDP and inflation and the Taylor rule, Litner and Cabell:

A) cannot predict how the target might change.

B) would forecast an increase in the target.

C) would forecast a decrease in the target.

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According to the Taylor rule, GDP growth being higher than the trend GDP growth would lead the central bank to increasing the target. However, inflation is lower than its target, which would mean the central bank would tend to lower the target for the short-term interest rate. Without additional information, it is not clear how the central bank will change the rate if at all. (Study Session 6, LOS 18.h)

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With respect to what the current shape of the yield curve indicates:

A) both Litner and Cabell are correct.

B) Litner is correct and Cabell is incorrect.

C) both Litner and Cabell are incorrect.

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If monetary policy is restrictive while fiscal policy is expansive, the yield curve will be more or less flat. (Study Session 6, LOS 18.i)

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In their discussion of the advantages of using economic indicators:

A) Litner is correct and Cabell is incorrect.

B) Litner is incorrect and Cabell is correct.

C) both Litner and Cabell are correct.

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The relationships do change over time, but the indicators can be adapted to various uses. (Study Session 6, LOS 18.n)

optiix

Which of the following describes a method of setting capital market expectations where a consistent set of experts is asked for their opinion regarding the future?

A) An algorithmic method.

B) A market-adjusted algorithmic method.

C) A panel method.

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Capital market expectations can also be formed using surveys. If the group polled is fairly constant over time, this method is referred to as a panel method.

burning0spear

Which of the following regarding the setting of capital market expectations is least accurate?

A) Surveys of practitioners have found them to be consistently more pessimistic than that of academics.

B) Analysts should adjust the forecasts from quantitative models using judgment, when appropriate.

C) When a fairly constant set of experts is polled, this method is referred to as panel method.

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Studies have found that the expectations of practitioners are consistently more optimistic than that of academics.

burning0spear

Which of the following regarding the setting of capital market expectations is least accurate?

A) Judgment can be applied to project capital market expectations.

B) Quantitative models should not be adjusted for an analyst’s subjective opinions.

C) Capital market expectations can also be formed using surveys.

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Although quantitative models provide objective numerical forecasts, there are times when an analyst must adjust those expectations using their insight to improve upon those forecasts.

burning0spear

Which of the following would indicate the greatest stimulation of economic growth?

A) Tax receipts increase due to changes in the economy.

B) Tax receipts increase due to a new government policy.

C) Tax receipts decline due to a new government policy.

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Only changes in the deficit directed by government policy will influence growth. A tax cut, which would result in lower tax receipts over the short-term, would stimulate the economy. Changes in the deficit that occur naturally over the course of the business cycle are not stimulative or restrictive. In an expanding economy, deficits will decline because tax receipts increase and disbursements to the unemployed decrease. The opposite occurs during a recession.

burning0spear

If inflation is targeted at 3%, exports are expected to rise by 5%, consumer spending is expected to increase at 1% and real GDP growth is expected at 2%, what would be the neutral interest rate in the economy?

A) 3%.

B) 5%.

C) 11%.

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The equilibrium interest rate in a country (the rate at which a balance between growth and inflation is achieved) is referred to as the neutral rate. It is generally thought that the neutral rate is composed of an inflation component and a real growth component. If inflation is targeted at 3% and the economy is expected to grow by 2%, then the neutral rate would be 5%. Exports and consumer spending are components of GDP and are thus already figured into the 2% GDP growth.

burning0spear

Which of the following regarding the use of monetary policy to stimulate growth or rein in inflation in an economy is most accurate?

A) Neither the direction of a change in interest rates nor the level of interest rates are important.

B) Only the direction of a change in interest rates is important.

C) Both the direction of a change in interest rates and the level of interest rates are important.

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Both the direction of a change in interest rates and the level of interest rates are important. If, for example, rates are increased to say 4% to combat inflation but this is still low compared to the neutral rate of 6% in a country, then this rate may still be low enough to allow growth and inflation to continue.

burning0spear

Suppose that Government A decreased the tariff on foreign goods and that Government B has moved to a lower marginal tax rate. Analyzing the effects on the long-term growth rate in the economy, which of the following would be most accurate?

A) Government A’s growth rate will decrease and Government B’s growth rate will decrease.

B) Government A’s growth rate will decrease and Government B’s growth rate will increase.

C) Government A’s growth rate will increase and Government B’s growth rate will increase.

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If the government decreases the tariff on foreign goods, competition should increase, increasing economic efficiency, and the long-term growth rate. The same is true of a cut in the tax rate (i.e., the long-term growth should increase).

burning0spear

Which phase of the business cycle is characterized by rising stock prices but increased investor nervousness?

A) Late expansion.

B) Initial recovery.

C) Slowdown.

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The late expansion phase of the business cycle is characterized by high confidence and employment, increases in inflation, rising bond yields, and rising stock prices. Investor nervousness increases risk during this period. The central bank also limits the growth of the money supply.