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 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.

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.

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 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

Suppose the analyst estimates a 1.8% dividend yield, long-term inflation of 3.4%, real earnings growth of 5.0%, an increase in shares outstanding of 0.6%, and a P/E repricing of 0.2%. What would be the expected return on the stock market?

A) 8.6%.

B) 11.0%.

C) 9.8%.

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The expected return on the stock market is 1.8% + 3.4% + 5.0% - 0.6% + 0.2% = 9.8%.

optiix

Which of the following statements best identifies and explains which bond is used as the expected return for a bond segment?

A) A coupon bond, because of the reinvestment rate assumption.

B) A zero coupon bond, because of the maturity assumption.

C) A zero coupon bond, because of the reinvestment rate assumption.

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The yield to maturity on a reference bond in a segment is used as the expected return. The drawback to this approach is that the yield to maturity assumes that intermediate cash flows are reinvested at the yield to maturity, which may be implausible if the yield to maturity is quite high. A zero coupon bond has no intermediate cash flows so it is not susceptible to the reinvestment rate assumption of the yield to maturity in a coupon bond. A zero coupon bond’s yield to maturity would be preferable to that of a coupon bond.

optiix

The use of appraisal data, relative to actual returns, results in:

A) correlations that are biased upwards and standard deviations that are biased upwards.

B) correlations that are biased downwards and standard deviations that are biased downwards.

C) correlations that are biased upwards and standard deviations that are biased downwards.

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The use of appraisal data, relative to actual returns, results in correlations that are biased downwards and standard deviations that are biased downwards. The reason is that price fluctuations are masked by the use of appraised data.

optiix

An analyst is forecasting the return for real estate assets. She has one year of monthly returns and would like to have enough data points for statistical purposes. Which of the following would be the most likely to result from her desire to use statistics?

A) Asynchronous data and upward biased correlations with equities.

B) Synchronous data and downward biased correlations with equities.

C) Asynchronous data and downward biased correlations with equities.

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Her desire to use statistics would most likely result in asynchronous data and downward biased correlations. Some researchers use more frequent data (e.g., using daily instead of monthly returns) in order to increase the length of the data. This however, increases the likelihood of asynchronous data. Asynchronous data results when, for example, the return for a real estate asset is not available on a given day. The researcher then replaces it with the previous day’s return. When measured against equity returns with readily available daily data, the real estate asset standard deviation and correlation with equity is artificially low.

optiix

Greg Wright, CFA, and Phil Bishop, CFA, are analysts and market forecasters for Far Horizons Forecasting, Inc. or FHF. They use a variety of data in their analysis, and Wright and Bishop have found it cost effective to use publicly available data from the Bureau of Labor Statistics as well as market data such as the yields of fixed income instruments of various maturities. Wright and Bishop have found inflation to be one of the most important inputs. They include the new announcement each quarter as it is released for the current quarter. Wright has insisted on using each new announcement for the current quarter. His goal is to avoid biases associated with placing too much weight on earlier information received and to allow their opinions to vary from previous opinions. However, Bishop has insisted that when inflation announcements deviate too far from the recent past, which in turn leads to a new capital market expectation very different from the recent observations, then they should revise the forecast to one closer to the recent average. A coworker, Cindy Post, CFA, recently cautioned Wright and Bishop concerning how inflation announcements must be used with caution. She says that the composition of the index, i.e., the items included in the index, can change over time. Daniel Paddington, CFA, also cautioned that the method of calculating the index can change over time, too. Post and Paddington caution that any forecasting model that does not account for these factors can lead to misleading results. Post and Paddington have been offering advice concerning other matters. Post sees that Wright and Bishop have not been including beta analysis in their capital market expectations. Post says that beta research is appropriate for capital market expectations because this research relates to systematic risk, which affects the whole market. In forming capital market expectations, Paddington feels they should also begin using alpha research, which addresses the movement of prices of assets within classes. The movements of short-term interest rates and bond yields as well as trends in the aggregate inventory-to-sales ratio are among the other inputs that Wright and Bishop already use in forming their capital market expectations. This is public data that Wright and Bishop find helpful in determining the present state of the economy. Currently they are observing that the rates on both Treasury bills and long-term Treasury bonds are increasing. Wright and Bishop also observe that the aggregate inventory-to-sales ratio is decreasing. Wright feels this is a good sign for business activity, but Bishop is pessimistic. Wright and Bishop have recently tried to build models for forecasting exchange rates. They have considered the various approaches: purchasing power parity, relative economic strength, capital flows and savings-investment imbalances. They have decided to combine purchasing power parity and relative economic strength for a more complete theory. Wright’s insistence that the newest inflation forecast be included in the model and Bishop’s insistence to adjust extreme forecasts are examples of:

A) attempting to avoid the anchoring trap but a possibility of falling into the status quo trap, respectively.

B) attempting to avoid both the anchoring trap and the status quo trap.

C) falling into the anchoring trap while attempting to avoid the status quo trap, respectively.

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Wright wants to avoid the anchoring trap, which occurs when an analyst places too much weight on earlier information and the associated expectation. Bishop wanting to not let forecasts deviate too far from the recent past is a good example of the status quo trap. (Study Session 6, LOS 18.b)

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With respect to the cautionary notes concerning inflation announcements given by Post and Paddington:

A) Post is correct and Paddington is incorrect.

B) both are incorrect.

C) both are correct.

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Post is pointing out the practice known as rebasing, which is the changing of an index to make sure the index truly reflects the current situation. In the case of the Consumer Price Index, for example, the goods must change to reflect changing consumer buying habits. Inflation indexes also change the weights or calculation methods over time. (Study Session 6, LOS 18.b)

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Based on Wright and Bishop’s observation concerning short-term and long-term rates, they should assess that the economy is in:

A) a recession.

B) a late expansion.

C) an early expansion.

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Both short-term and long-term rates increase in an expansion. (Study Session 6, LOS 18.e)

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With respect to the advice that Post and Paddington offer concerning the use of beta research and alpha research, respectively, in the forming of capital market expectations:

A) Post is correct and Paddington is incorrect.

B) Post is incorrect and Paddington is correct.

C) both Post and Paddington are correct.

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The definitions are correct, and alpha research does focus on individual assets, but that is why Paddington is incorrect. Alpha is generally not included in models of capital market expectations. (Study Session 6, LOS 18.a)

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There is a traditional interpretation to changes in the aggregate inventory-to-sales ratio. With respect to the mentioned trend in the aggregate inventory-to-sales ratio and the reaction by Wright and Bishop, we would most likely say:

A) both Wright and Bishop are using different versions of the traditional interpretation.

B) that Wright is using the traditional interpretation and Bishop is not.

C) that Bishop is using the traditional interpretation and Wright is not.

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The traditional interpretation is that a decreasing inventory-to-sales ratio is a negative sign because businesses are preparing for a decrease in business, and this is congruous with Bishop’s pessimism. Wright’s optimism is probably from a new view that firms have been able to lower their levels of inventory with the help of technology. (Study Session 6, LOS 18.e)

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With respect to forecasting exchange rates, combining purchasing power parity (PPP) and relative economic strength for a more complete theory is:

A) not appropriate because both purchasing power parity and relative economic strength are long-term forecasting tools.

B) appropriate because purchasing power parity pertains to short-run announcements and relative economic strength adjusts to long-run equilibrium.

C) appropriate because purchasing power parity pertains to long-run equilibrium and relative economic strength adjusts to short-term announcements.

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It can be helpful to combine the PPP and relative strength approaches. The relative strength approach indicates the response to news on the economy but does not tell us anything about the level of exchange rates. The PPP approach indicates what level of the exchange rate can be regarded as a long-term equilibrium. By combining the two, we can generate a more complete theory. (Study Session 6, LOS 18.q)