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Portfolio Management and Wealth Planning【Reading 18】

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.



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.

Which of the following is NOT a characteristic of a good forecast using capital market expectations? The forecasts:
A)
have a minimum amount of forecast error.
B)
are subjectively formed.
C)
are consistent with the forecasts used for other assets.



High-quality forecasts are objectively formed. They are also consistent, unbiased, well supported, and have a minimum amount of forecast error.

TOP

Frank Bowden is formulating the expected returns, standard deviations, and correlations for bonds and equities given global economic forecasts. Tom Weatherford is examining the returns to a U.S. small-cap stock based on analyst's forecasted returns versus the capital asset pricing model and the security market line. Which of the following about Bowden and Weatherford is most accurate?
A)
Bowden is performing alpha research and Weatherford is performing beta research.
B)
Bowden is performing beta research and Weatherford is performing alpha research.
C)
Bowden is performing beta research and Weatherford is performing beta research.



Bowden is performing beta research and Weatherford is performing alpha research. Beta research involves setting capital market expectations for broad asset classes. It is referred to beta research because it is related to systematic risk. Alpha research is concerned with earning excess returns through the use of specific strategies within specific asset groups.

TOP

Xavier Fellows works in the research department of Multinational Inc., a large investment bank. He is tasked with forecasting economic conditions to support the bank's money managers and traders.
Fellows takes his work seriously and is considered to be an excellent forecaster. His economic forecasts are updated monthly and sent to most of Multinational’s analysts and money managers. The analysts use Fellows' forecasts as the basis for their own research on specific securities or asset classes.
However, Fellows is concerned that his forecasts are not accurate enough. In an effort to avoid making mistakes, Fellows follows a detailed process to develop accurate and usable forecasts. Fellows hopes that this process will help him avoid some of the common problems of forecasts. Here is his system:
  • Establish a benchmark for market expectations. Multinational serves thousands of clients with different investment goals and constraints, and Fellows knows analysts will need the different benchmarks for a variety of different types of investors.
  • Look at the historical returns of a number of asset classes to act as a check on forecasts for each asset class.
  • Assemble data on historical returns and valuations for all relevant asset classes, considering potential biases, adjusting the numbers to account for different calculation methods, and ensure that data definitions match those used by the company that collected the data.
  • Interpret the data. Fellows uses his years of experience to extrapolate that data into growth and valuation assumptions for each asset class. This step is the most subjective.
  • Distill assumptions into top-down forecasts, detailing the assumptions and methods for interpreting historical data in the event that individual analysts want to use data to create their own industry-specific forecasts.
  • Monitor performance. If Fellows’ forecasts prove to be inaccurate, he works to improve his models.

This month's forecast dwells heavily on inflation projections and their expected effect on the returns of different asset classes. Fellows projects a decline in inflation and predicts that bond yields have bottomed out.
Stock analyst Karen Andrews calls Fellows after the report is released with some questions about his analysis. She is pleased with the work, but a bit disappointed that he did not include information on current and estimated bond yields.
Andrews asks Fellows to forward his analysis of the inflation picture to Carol Huggins, a colleague who works in the bank's money-management business. Huggins consults on money-management issues with large clients and is very interested in inflation projections.
Lester Canfield, who manages money on a discretionary basis for high-net-worth individual investors, is also interested in Fellows' forecast. After reading the entire document, he decides to sell some of his clients' interest in a limited partnership that develops and manages real estate, and invest that money in high-yield bonds. Canfield's reasoning is threefold:
  • Canfield believes the partnership has excellent return potential, but he is the only one who expects such robust results. The bonds seem to be a safer investment, and Canfield does not want to guess wrong.
  • Historically, average high-yield bond returns are higher than the returns of real estate partnerships.
  • During periods of falling inflation, real estate investments often lag the market.

Before making the move, Canfield calls Fellows to get an opinion on his plan. After hearing Canfield's rationale, Fellows advises against the move into high yield bonds.Fellows skipped a step in his technique for producing forecasts. He forgot to:
A)
identify a valuation model used in his analysis.
B)
identify where he obtained his data.
C)
assure that the underlying data is accurate.



Fellows' plan mirrors the seven-step process for formulating capital-market expectations in every aspect except one, identifying the valuation model used in the analysis. Assuring the accuracy of data and identifying its source are important, but they would presumably fall under steps three and five of Fellows' process. (Study Session 6, LOS 18.a)

Fellows' advice to Canfield suggests Canfield is least likely suffering from:
A)
the prudence trap.
B)
the recallability trap.
C)
failing to use conditioning information.



The relationship between historical returns and economic variables is not constant over time, and Canfield may not be considering information about changing economic conditions that affected real-estate returns over short periods of time. Analysts fall into the prudence trap when they become overly conservative because they are afraid of being wrong. The use of ex post (after the fact) data to interpret ex ante (before the fact) actions is risky. There may be other factors, whether correlated with inflation or independent, that caused subpar real estate returns. The recallability trap has to do with allowing dramatic events to affect forecasts. This issue is not relevant here. (Study Session 6, LOS 18.b)

Andrews most likely requested bond yields because she wanted to:
A)
analyze stock-market valuations using the risk premium approach.
B)
develop a shrinkage estimate.
C)
gauge potential fixed-income investments.



The risk premium approach uses bond yields and an equity risk premium to project market returns. Since Andrews is an equity trader, it is unlikely she is interested in fixed-income investments. The question of shrinkage estimators is not relevant here. (Study Session 6, LOS 18.c)

Which of the following is least likely a common problem encountered in forecasting?
A)
Data measurement errors and biases.
B)
It is difficult to use multiple regression analysis.
C)
Failing to account for conditioning information.


There are nine problems in producing forecasts:
  • limitations to using economic data
  • data measurement error and bias
  • limitations of historical estimates
  • the use of ex post risk and return measures
  • non-repeating data patterns
  • failing to account for conditioning information
  • misinterpretations of correlations
  • psychological traps
  • model and input uncertainty


Due to the problem of misinterpretation of correlations, it is often useful to run multiple regressions. An analyst may discover a stronger relationship between two variables that was not evident using simple linear regression analysis. (Study Session 6, LOS 18.b)


Due to the decline in inflation and the low bond yields, Fellows should conclude that the economy is most likely in what stage of the business cycle?
A)
Slowdown.
B)
Late expansion.
C)
Initial recovery.



In general, inflation rises in the latter stages of an expansion and falls during a recession and the initial recovery. Bond yields peak during a slowdown and fall during a recession, however, they bottom out during the initial recovery stage. (Study Session 6, LOS 18.e)

Which of the following is least accurate regarding inflation?
A)
Declining inflation results in declining economic growth and asset prices.
B)
Highly levered firms are most affected by declining inflation rates.
C)
Low inflation affects the return on cash instruments.



Low inflation can be beneficial for equities if there are prospects for economic growth free of central bank interference. Declining inflation usually results in declining economic growth and asset prices. The firms most affected are those that are highly levered because they are most sensitive to changing interest rates. Low inflation does NOT affect the return on cash instruments. (Study Session 6, LOS 18.g)

TOP

A return index that tracks the NASDAQ stock market index can be subject to:
A)
survivorship bias and hence downward biased returns.
B)
survivorship bias and hence upward biased returns.
C)
backfill bias and hence upward biased returns.



Survivorship bias can result when a return series is based on a stock index. It will be biased upwards if the return calculation does not include firms that have been dropped from the index due to delistings.

TOP

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.



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)

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.



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)

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.



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

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.



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)

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.



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)

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.



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)

TOP

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.



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.

TOP

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.



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.

TOP

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.



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.

TOP

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%.



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

TOP

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