Portfolio Management and Wealth Planning【Reading 18】 regarding, following, capital

optiix

Which of the following regarding the formulation of capital market expectations is least accurate? An analyst should:

A) consider the investor’s tax status, allowable asset classes, and time horizon.

B) vary their assumptions when interpreting data and drawing conclusions.

C) investigate assets’ historical performance and their determinants.

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In the fifth step of the formulation of capital market expectations, the analyst should use a consistent set of assumptions when interpreting data and drawing conclusions.

manchester88

Which of the following is most representative of an exogenous economic shock?

A) A hurricane hitting the Gulf of Mexico resulting in the shut-down of many oil wells and refineries and to higher oil prices.

B) Ongoing expansionary fiscal policy by the federal government leading to higher inflation and interest rates.

C) Anticipated loose monetary policy by a country’s central bank leading to inflation and to depreciation in the country’s currency.

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An exogenous shock is something that occurs outside the normal course of an economy, such as a natural disaster or unanticipated government policy. The shock is unanticipated and is not part of a trend as would be characterized by ongoing monetary or fiscal policy.

manchester88

Which one of the following represents possibly the most difficult task the government faces in the event of an exogenous shock?

A) Rebuilding infrastructure after a natural disaster.

B) Preventing the shock from becoming a contagion and spreading to its own country.

C) Being able to lower interest rates in a deflationary environment.

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Banks are usually severely impacted by a financial crisis shock. In reaction the country’s central bank attempts to stabilize the banking system and the economy by injecting liquidity into the system by maintaining or lowering interest rates. It would be virtually impossible to lower interest rates further in an already low inflation, low interest rate, or deflationary environment. Although rebuilding after a major natural disaster could be difficult it would still be possible given enough resources. A country can prevent or minimize the impact of a contagion spreading to its own country due to a financial shock by having sound fiscal and monetary policies that will prevent the country from defaulting on its debt and prevent or minimize the impact of financial bubbles.

manchester88

Which of the following statements least likely represents a scenario from an exogenous shock?

A) Political unrest in the Middle East leading to an unexpected decrease in oil production, increased oil prices, decreased consumer spending, increased unemployment, and a slowed economy.

B) A country defaults on its debt payments, thereby causing the country’s currency to lose value and forcing the central bank to take measures to stabilize the banking system and the economy.

C) OPEC not being able to agree on production levels leading to increased uncertainty in global markets and increased oil prices.

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Exogenous shocks usually lead to economic slowdowns, as in the case of an oil shock leading to higher prices, inflation, reduced consumer spending, increased unemployment, and a slowing economy. A reduction in oil prices could be caused by a weak global economy with weak demand for oil or an oversupply of oil in the global market. This would reduce the price of oil and boost the economy, potentially overheating it in which causes high inflation and increased interest rates that ultimately slow the economy down. In a financial crisis the result is usually characterized by banks becoming vulnerable and requiring action by the central bank to stabilize the banking system and economy by increasing liquidity and lowering interest rates.

manchester88

Suppose the U.S. has higher inflation than Japan. The U.S. is in the late expansion phase of the business cycle and Japan is in the initial recovery phase. Using only the PPP relationship for forecasting currency values and using the relationship between asset class returns and the business cycle, which asset should the manager invest in?

A) Japanese stocks.

B) Japanese bonds.

C) U.S. bonds.

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The PPP relationship states that countries with high inflation will see their currency depreciate, so the manager should invest in Japan. Within Japan, the investor should invest in stocks because stock prices have just started to rise and will continue to do so for some time. Bond yields will soon rise and their prices will fall as the economy expands.

manchester88

During which phase of the business cycle would TIPS be least useful to a portfolio manager?

A) Early expansion.

B) Slowdown.

C) Initial recovery.

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U.S. Treasury Inflation Protected Securities (TIPS) are protected against increases in inflation. They would be needed the least when inflation is falling. During the initial recovery phase of the business cycle, inflation is falling.

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Suppose a cash manager has an investment horizon of one-year. She has the choice of investing in either commercial paper with a maturity of six-months or commercial paper with a maturity of one-year. If she pursues the former, she will roll over her investment in six months to another six-month instrument. The current rates are 5% annually on the six-month commercial paper and 5.5% for the one-year maturity commercial paper. If in six months, the yield for six-month commercial paper is 5.2% annually, should she invest in the two six-month instruments or the one-year commercial paper? Also assume that she can utilize this strategy in either Country A or Country B. If Country A has a savings deficit and Country B has a savings surplus, which country should she invest in if she is using a savings-investment imbalances approach to forecast currency values?

A) One-year in Country A.

B) Six-month in Country A.

C) One-year in Country B.

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She should invest in the one-year commercial paper. By locking in the higher rate of 5.5% over the one-year, she will earn a higher return than she would have if she had invested in two successive six-month commercial paper notes of 5.0% and 5.2% [=(1+.05/2)(1+.052/2)-1=5.17%]. The savings-investment imbalances approach to forecasting currency values states that countries with savings deficits will have to have strong currency values to attract foreign capital. A strong currency benefits the investor so she should invest in Country A.

manchester88

The savings-investment imbalances approach would most likely project a strong domestic currency during which phase of the economy?

A) Late recession.

B) Early expansion.

C) Slowdown.

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A savings deficit exists when investment is greater than domestic savings. To compensate for a savings deficit, a country’s currency must increase in value and stay strong to attract and keep foreign capital. This scenario typically occurs during an economic expansion when businesses are optimistic and use their savings to make investments. Eventually though the economy slows, investment slows, and domestic savings increase. It is at this point that the currency will decline in value.

manchester88

Which of the following statements regarding the relationship between a domestic currency value and interest rates is most accurate?

A) An increase in short-term interest rates decreases the value of the domestic currency.

B) An increase in short-term interest rates increases the value of the domestic currency.

C) An increase in short-term interest rates may increase or decrease the value of the domestic currency.

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Higher interest rates generally attract capital and increase the domestic currency value. At some level though, higher interest rates will result in lower currency values because the high rates may stifle an economy and make it less attractive to invest there.

manchester88

Suppose the U.S. has a persistent current account deficit. Which of the following approaches to forecasting currencies best explains why the U.S. dollar will be strong during this time period?

A) The savings-investment imbalances approach.

B) The capital flows approach.

C) The relative economic strength approach.

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The savings-investment imbalances approach begins by stating that a savings deficit exists when investment is greater than domestic savings. To compensate for a savings deficit, a country’s currency must increase in value and stay strong to attract and keep foreign capital. At the same time the country will have a current account deficit where exports are less than imports. Although a current account deficit would normally indicate that the currency would weaken, the currency must stay strong to attract foreign capital.