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Reading 23: Capital Market Expectations- LOS c~ Q1-10

 

LOS c: Demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models.

Q1. 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 and they are assuming correlation is causation.

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

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

 

Q2. Using the results of the estimated factor models, the forecasted covariance of FGI and VCC would be closest to:

A)   0.0244.

B)   0.0488.

C)   0.0477.

 

Q3. With respect to their comments concerning the relative volatility and size of business spending with respect to consumer spending Litner:

A)   and Cabell are both incorrect.

B)   is correct and Cabell is incorrect.

C)   is incorrect and Cabell is correct.

 

Q4. 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)   would forecast an increase in the target.

B)   would forecast an increase in the target.

C)   cannot predict how the target might change.

 

Q5. With respect to what the current shape of the yield curve indicates:

A)   Litner is correct and Cabell is incorrect.

B)   both Litner and Cabell are incorrect.

C)   both Litner and Cabell are correct.

 

Q6. 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.

 

Q7. Which of the following statistical tools adjusts historical estimates using a weighted average of the historical value and an analyst-determined value?

A)   Shrinkage estimator.

B)   Multifactor model.

C)   Time series analysis.

 

Q8. Suppose the analyst estimates a 1.8% dividend yield, long-term inflation of 3.4%, 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%.

 

Q9. Which of the following statements best identifies and explains which bond is used as the expected return for a bond segment?

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

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

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

 

Q10. Suppose an analyst is valuing two markets. Market A is a developed country market and Market B is an emerging market. What is the expected return for the emerging market given the following information?

Sharpe ratio of the global portfolio   

0.29

Standard deviation of the global portfolio   

8.00%

Risk-free rate of return   

4.00%

Degree of market integration for Market A   

80%

Degree of market integration for Market B   

65%

Standard deviation of Market A   

18.00%

Standard deviation of Market B   

27.00%

Correlation of Market A with global portfolio   

0.86

Correlation of Market B with global portfolio   

0.61

Estimated illiquidity premium for A   

0.00%

Estimated illiquidity premium for B  

2.50%

A)   12.35%.

B)   8.35%.

C)   9.85%.

Thanks

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