Portfolio Management【Reading 62】Sample 2012, management, impressive, experience

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Gerald Santana, CFA is the president and CEO of Dartmouth Ltd., a hedge fund management firm located in New York. The firm has been in existence for nearly fifteen years, and has shown consistently impressive returns since inception. Dartmouth has a wide variety of investments across a broad range of asset types that are based around the world. Members of the firm have a great deal of experience in assessing the currency exposure associated with investing in international markets. Due to a recent influx of new funds, Santana and his team have a substantial amount of uninvested cash and are currently evaluating several investment opportunities.
One potential investment for the fund is a 25 percent stake in a closely-held manufacturing company located in Ireland which produces textiles for export to the United States. Prices are set and paid for in U.S. dollars, but all costs of production are incurred in Euros. Santana is somewhat concerned about the potential currency exposure of the company, although he is quite familiar with the risks involved with investing in foreign firms with multinational operations. He intends to do further analysis of expected returns given various anticipated interest rate and exchange rate scenarios.
Additionally, Santana is considering placing some interim funds in some British bonds that appear cheap and are currently yielding a premium over other country’s comparable securities. In his opinion, inflation rates should remain reasonably stable over the next year and the real exchange rate between the two countries is expected to remain constant. The securities are highly liquid, so he does not anticipate any problem selling the bonds should he decide to liquidate the position prior to his anticipated one-year holding period.
Current spot rates:

• U.S. Dollar ($) per Euro (€) 0.7600
• U.S. Dollar ($) per British pound (₤): 0.5100

Current 1-year interest rates:

• United States 4.50%
• Great Britain 6.25%

Expected one-year inflation rates:

• United States 2.25%
• Great Britain 5.00%

International market efficiency is an effective impediment for managers from utilizing active asset allocation between countries to consistently beat the world index. However, there are six potential impediments to the international flow of capital. Which of the following factors is least likely to have an impact on market efficiency?

A) Psychological barriers.

B) Interest rate risk.

C) Legal restrictions.

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Interest rate risk, although present across all markets, is not one of the six potential barriers to international capital mobility. The other three barriers are transaction costs, political risks, and foreign currency risk. (Study Session 18, LOS 62.a)

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Which of the following statements regarding real exchange rates and domestic currency return is least accurate?

A) Real exchange rate risk occurs if the nominal exchange rate does not change by the amount predicted by the inflation differential.

B) The real exchange rate is the spot exchange rate divided by the ratio of the consumption basket price levels.

C) Real exchange rate movements are defined as changes in the nominal exchange rate that are not explained by inflation differentials.

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The real exchange rate is the spot exchange rate multiplied by the ratio of the consumption basket price levels. (Study Session 18, LOS 62.e)

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If the Euro experiences 7 percent real appreciation versus the dollar, the value of the investment in the Irish company will be impacted, all other things equal. Which of the following statements best describes the impact on Dartmouth’s investment? The Irish company will be:

A) hurt by the appreciation of the Euro because the firm’s products will be more expensive in the United States.

B) helped by the appreciation of the Euro because its costs of production will decline.

C) hurt by the appreciation of the Euro because its costs of production will increase.

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The currency appreciation will make the company’s products more expensive in the U.S., which will decrease sales. Costs will remain the same, so profitability will decline. (Study Session 18, LOS 62.l)

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According to the money demand model of equity exposure for a company, which of the following statements is most accurate? The money demand model:

A) predicts that currency depreciation will lead to lower equity prices in a developed country.

B) predicts that depreciation in the value of the domestic currency will cause an increase in the competitiveness of domestic industry.

C) explains the positive correlation between changes in domestic currency and stock returns.

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According to the money demand model, increased real economic activity leads to increased demand for the domestic currency. This increase in domestic currency demand causes the value of the domestic currency to appreciate, which in turn leads to increased stock returns. (Study Session 18, LOS 62.n)

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Santana wants to quantify the additional exchange rate risk associated with the purchase of the British securities. Calculate the expected exchange rate change at the end of one year.

A) 0.4960.

B) 0.5215.

C) 0.5240.

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If real rates remain constant, the change in the exchange rate is equal to the inflation differential. The current difference between the two countries rates is 2.75% (5.00% − 2.25%), so the expected depreciation of the pound is 2.75%. The expected exchange rate is calculated as: $0.5100/₤ × (1 − 0.0275) = $0.4960/₤ (Study Session 18, LOS 62.f)

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Assume that the British pound will depreciate by 3 percent over the next year. Calculate the hedge fund’s expected return on the British investment for a one year holding period.

A) 3.00%.

B) 3.25%.

C) 4.50%.

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The hedge fund is located in New York, so the domestic currency is the U.S. $. The expected dollar return on the British bond for one year is approximately equal to the British interest rate minus the depreciation of the pound. Therefore: 6.25% - 3.00% = 3.25% (Study Session 18, LOS 62.f)

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John Swanson is an economic advisor for the international division of BMC Investments. He has been asked to gather economic data and present a seminar to other analysts regarding international economic concerns. The following three issues were raised in the seminar. Choose the most reasonable statement that Swanson should make in replying to the questions raised.The issue of growth rates across various countries was discussed and there was some disagreement regarding future expectations for growth rates across countries. Which of the following statements most accurately describe expectations of future growth rates under neoclassical theory?

A) The best method for measuring the difference in growth rates internationally is using endogenous growth theory.

B) Conditional convergence is predicted for countries with similar economic attributes, including savings and population growth rates.

C) High-growth countries that have historically made high investment for growth will ultimately enter a steady state.

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Under neoclassical theory the concept of convergence implies that high-growth countries that have historically made high investment for growth will ultimately enter a steady state. Absolute convergence, not conditional convergence, is predicted for countries with similar economic attributes, including savings and population growth rates. There is empirical evidence to suggest that countries that invest more will grow faster, but the accelerated growth is not permanent. Endogenous (new) growth theory is not of much value in explaining differences in growth rates internationally.

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The vice president of equity analysis believes that Japan is an integrated world market with few impediments to international flow of capital. Which of the following factors would NOT cause Swanson to question the international efficiency of Japan?

A) The gross domestic product (GDP) is less for Japan than the local GDP.

B) Foreign currency risk is not completely hedged away.

C) The accounting system in Japan is not in accordance with Generally Accepted Accounting Principles (GAAP).

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The level of GDP is not a factor in questioning the international efficiency of a country. In addition to the other factors mentioned in this question, there are several other impediments to international flow of capital. The six potential impediments to international flow of capital are psychological barriers, legal restrictions, transaction cost, discriminatory taxation, political risks, and foreign currency risk.

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Swanson has reason to believe that Japan will soon be making monetary policy changes that will cause the yen to suddenly depreciate 1%. If the value of a Japanese firm falls when the yen depreciates, the asset return and currency movement are:

A) negatively correlated from a U.S. investor's perspective which exaggerates the currency movement impact.

B) positively correlated from a U.S. investor's perspective which lessens the currency movement impact.

C) positively correlated from a U.S. investor's perspective which exaggerates the currency movement impact.

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If the value of a Japanese firm falls when the yen depreciates, the asset return and currency movement are positively correlated from a U.S. investor’s perspective, and this exaggerates the currency movement impact.

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Which of the following is considered an impediment to international capital mobility?

A) Foreign currency risk.

B) Greek risk.

C) Market risk.

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Foreign currency risk is an impediment to international capital mobility. The other risks listed exist in any market, domestic or international (note: Greek risk refers to derivative securities models).

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Which of the following is NOT an impediment to international capital mobility?

A) Psychological barriers.

B) Model risk.

C) Discriminatory taxation.

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The impediments to international capital mobility do not include model risk. Model risk exists in all markets.

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If the international markets are segmented, which of the following is most accurate?

A) Risk will not be priced the same in all markets.

B) The international capital asset pricing model will still be valid.

C) The extended capital asset pricing model must be used to price international assets.

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If markets are segmented, then assets with similar risk/return parameters will not necessarily be priced the same.

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Which of the following is NOT a factor that favors international market integration?

A) Many institutional investors diversify internationally.

B) Governments borrow and lend internationally.

C) International tax laws are determined by the International Monetary Fund (IMF).

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There is little in the way of uniform international tax law. Further, the IMF does not determine tax law. The other factors listed promote market integration.

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International market integration requires significant international capital mobility. In terms of volume of transactions, what has happened to international capital flows over the past two decades?

A) As a percent of domestic gross domestic product (GDP), international capital flows have remained constant.

B) International capital flows have increased modestly.

C) International capital flows have increased dramatically.

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The past two decades have witnessed large increases in the volume of international capital flows.

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Which of the following will NOT encourage international market integration?

A) International political stability.

B) Absence of trade restrictions.

C) Widespread use of the international capital asset pricing model (ICAPM).

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Widespread use of the ICAPM will not enhance market integration. If markets are integrated, then the ICAPM will be a useful model for international asset pricing.

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Users of the capital asset pricing model (CAPM) must assume that:

A) inflation remains moderate.

B) all investors are risk-averse.

C) exchange rates are not excessive.

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One of the assumptions of the CAPM is that all investors are risk-averse, preferring more return and less risk, all else equal. The other assumptions are not required.

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Horace Malthusson likes to use the CAPM in his stock valuation. When using the CAPM to value stocks, Malthusson assumes that he can borrow money at the risk-free rate, tax rates are stable, and every investor has the same expected rate of return. The assumptions required by the CAPM differ from Malthusson’s assumptions with regard to:

A) expected returns.

B) tax rates.

C) borrowing capability.

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The capital asset pricing model requires that investors assume there are no taxes. Malthusson’s other assumptions match those of the CAPM.