Reading 23: Capital Market Expectations- LOS n～ Q1-3

black, returns, economic, 2009

LOS n: Demonstrate the use of economic information in forecasting asset class returns. fficeffice" />

Q1. If a cash manager thought the economy was going to have a robust recovery, (s)he would:

A) shift from longer-term cash instruments to shorter-term cash instruments and from more credit worthy instruments to less credit worthy instruments.

B) shift from shorter-term cash instruments to longer-term cash instruments and from more credit worthy instruments to less credit worthy instruments.

C) shift from longer-term cash instruments to shorter-term cash instruments and from less credit worthy instruments to more credit worthy instruments.

Correct answer is A)

Interest rates will increase during a robust expansion. If a manager thought that interest rates were set to rise, (s)he would shift from say nine-month cash instruments down to three-month cash instruments. If (s)he thought that the economy was going to improve so that less creditworthy instruments would have less chance of default, (s)he would shift more assets into lower rated cash instruments. Longer maturity and less creditworthy instruments have higher expected return, but also more risk.

Q2. Which of the following statements regarding emerging market government debt is most accurate? Emerging market government debt is usually denominated in:

A) a non-domestic currency which makes them less credit risky.

B) a non-domestic currency which makes them more credit risky.

C) the domestic currency which makes them more credit risky.

Correct answer is B)

The key difference between developed country government bonds and emerging market government bonds is that most emerging debt is denominated in a non-domestic currency (e.g., dollars, euros, etc.). The emerging government must obtain a hard currency to pay back the principal and interest. The default risk for emerging market debt is thus much higher.

Q3. Which of the following statements regarding interest rates and yields is most accurate?

A) An increase in short-term rates increases the yields on long-term bonds.

B) An increase in short-term rates may increase or decrease the yields on long-term bonds.

C) Short-term rates are independent of the yields on long-term bonds.

Correct answer is B)

A change in short-term rates has unpredictable effects. Usually an increase in short-term rates increases the yields on bonds. Bond yields may actually fall though if the interest rate increase is sufficient to slow the economy.