Schweser QBank 2017 portfolio management and wealth planning 07 applications of economic analysis to portfolio management

Applications of Economic Analysis to Portfolio Management
Test ID: 7427706

Question #1 of 99

Question ID: 465348

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%

ᅞ A) 8.35%.
ᅚ B) 12.35%.
ᅞ C) 9.85%.
Explanation
For practice, we calculate the expected returns for both markets. First, we calculate the equity risk premium for both markets
assuming full integration. Note that for the emerging market, the illiquidity risk premium is added in:

Next, we calculate the equity risk premium for both markets assuming full segmentation:

We then weight the integrated and segmented risk premiums by the degree of integration and segmentation in each market:

The expected return in each market figures in the risk-free rate:


Question #2 of 99

Question ID: 465370

Which of the following statements regarding spending and the business cycle is least accurate?
ᅚ A) Business spending is less volatile than consumer spending.
ᅞ B) As a percentage of GDP, consumer spending is much larger than business spending.
ᅞ C) The inventory cycle is shorter than the business cycle.
Explanation
Business spending is more volatile than consumer spending. Spending by businesses on inventory and investments are quite
volatile over the business cycle. As a percentage of GDP, consumer spending is much larger than business spending. The
inventory cycle typically lasts two to four years whereas the business cycle has a typical duration of nine to eleven years.

Question #3 of 99

Question ID: 465367

Which asset would perform the worst during deflationary periods?
ᅚ A) Real estate financed with debt.
ᅞ B) Corporate bonds.
ᅞ C) Real estate wholly owned.
Explanation
Deflation reduces the value of investments financed with debt. In the case of real estate, if the property is levered with debt,
losses in its value lead to steeper declines in the investor's equity position. As a result, investors flee in an attempt to preserve

their equity and prices fall further. Bond prices will rise during deflationary periods when inflation and interest rates are
declining.

Question #4 of 99

Question ID: 465410

Using the data provided, rank the following variables in descending order of their impact on real economic output: change total
factor productivity (TFP), change in labor input (labor), and change in capital input (capital).
Expected growth in real economic
output
Expected growth in total factor
productivity
Expected growth in the labor
Expected growth in capital stock, α =
0.4

2%

1%
1%
1%


ᅚ A) TFP, labor, capital.
ᅞ B) Capital, TFP, labor.
ᅞ C) Labor, capital, TFP.
Explanation
From the Cobb-Douglas production function we know that real economic output will change by: the same percentage change
as TFP, α times the percentage change in capital input, and (1 − α) times the change in labor input. Consider a 1% increase in

each of the three variables individually while holding the others constant. Using the Cobb-Douglas function below and an alpha
of 0.4, we can see that Δy = 1.0% for a 1% change in TFP (%ΔA), 0.4% for a 1% change in capital, and 0.6% for a 1% change
in labor.
%ΔY = %ΔA + α(%ΔK) + (1 − α)(%ΔL)
= 1.0% + 0.4(1.0%) + (0.6)(1.0%)

Question #5 of 99

Question ID: 465384

An analyst believes that a recession is likely to develop that will affect many of the world economies. She believes that Country
A's GDP should be forecast using current and lagged economic data for it as well as from other countries that may influence
Country A. What type of country is Country A and what type of forecasting model should be used? Country A is most likely a:
ᅞ A) small country and its GDP should be forecast using a checklist approach.
ᅚ B) small country and its GDP should be forecast using an econometric approach.
ᅞ C) large country and its GDP should be forecast using an econometric approach.
Explanation
Small countries with undiversified economies are more susceptible to global events. Larger countries with diverse economies
are less affected by events in other countries. An econometric approach can be very complex, involving several data items of
various time periods lags to predict the future. They can be used to accurately model real world conditions.

Question #6 of 99

Question ID: 465374

Calculate the short-term interest rate target given the following information.

Neutral rate

4.00%

Inflation target

2.00%

Expected Inflation

5.00%

GDP long-term trend

3.00%

Expected GDP

1.00%

ᅞ A) 5.0%.
ᅞ B) 6.5%.
ᅚ C) 4.5%.


Explanation

The weak projected economic growth calls for cutting interest rates. If inflation were not a consideration, the target interest
rate would be 1% lower than the neutral rate. However, the higher projected inflation overrides the growth concern and the
targeted rate is actually higher than the neutral rate.

Question #7 of 99

Question ID: 465405

During which phase of the business cycle would TIPS be least useful to a portfolio manager?
ᅚ A) Initial recovery.
ᅞ B) Slowdown.
ᅞ C) Early expansion.
Explanation
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.

Question #8 of 99

Question ID: 465402

Which of the following statements regarding the relationship between a domestic currency value and interest rates is most
accurate?
ᅞ A) An increase in short-term interest rates decreases the value of the domestic
currency.
ᅚ B) An increase in short-term interest rates may increase or decrease the value of the
domestic currency.
ᅞ C) An increase in short-term interest rates increases the value of the domestic currency.
Explanation
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.

Question #9 of 99
Which of the following would indicate that a country is less affected by global events? The country is:
ᅚ A) large and has a diversified economy.
ᅞ B) small and has a diversified economy.

ᅞ C) small and has an undiversified economy.

Question ID: 465385


Explanation
Larger countries with diverse economies are less affected by events in other countries. Small countries with undiversified
economies are more susceptible to global events.

Question #10 of 99

Question ID: 465366

Which phase of the business cycle is characterized by rising stock prices but increased investor nervousness?
ᅞ A) Slowdown.
ᅞ B) Initial recovery.
ᅚ C) Late expansion.
Explanation
The late expansion phase of the business cycle is characterized by high confidence and employment, increases in inflation,
rising bond yields, and rising stock prices. Investor nervousness increases risk during this period. The central bank also limits
the growth of the money supply.

Question #11 of 99

Question ID: 465427

Given an S&P 500 forward earnings yield of 7.2% and 10-year Treasury notes yielding 2.68%, which of the following
interpretations of this data using the Fed model is most accurate?
ᅞ A) The spread between the S&P 500 earnings yield and the Treasury notes is too
great to make an informed decision.

ᅞ B) Since the S&P 500 is earning significantly more than the Treasuries this indicates the
S&P 500 equity market is overvalued.
ᅚ C) The S&P 500 earnings yield is higher than the Treasury yield indicating that equities
are undervalued and should increase in value.
Explanation
The Fed model assumes that the expected operating earnings yield on the S&P 500 (i.e., expected aggregate operating
earnings divided by the current index level) should be the same as the yield on long-term U.S. Treasuries:

If the S&P 500 earnings yield is higher than the treasury yield, the interpretation is that the index value is too low relative to
earnings. Equities are undervalued and should increase in value.

Question #12 of 99

Question ID: 465350

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?
ᅞ A) 11.0%.


ᅚ B) 9.8%.
ᅞ C) 8.6%.
Explanation
The expected return on the stock market is 1.8% + 3.4% + 5.0% - 0.6% + 0.2% = 9.8%.

Question #13 of 99

Question ID: 465422

Which of the following statements regarding Tobin's q and the equity q is least accurate?

ᅚ A) The equity q compares the aggregate market value of the firm's equity to the
market value of the firm's net worth.
ᅞ B) The equilibrium value for both Tobin's q and the equity q is 1.
ᅞ C) Tobin's q compares the current market value of a company to the replacement cost of
its assets.
Explanation
The equilibrium value of both Tobin's q and the equity q is assumed to be 1.0.
Tobin's q compares the current market value of a company to the replacement cost of its assets. The thinking is that the sum
of the replacement values of the individual assets should be the same as their aggregate market value, as reflected in the sum
of the market values of the firm's debt and equity. The theoretical value of Tobin's q is 1.0. If the current Tobin's q is above
(below) 1.0 the firm's stock is presumed to be overpriced (underpriced).
The equity q focuses directly on equity values and is interpreted the same way as Tobin's Q. It compares the aggregate
market value of the firm's equity to the net worth at replacement value, not market value. That is the reason the statement is
false. The replacement value is measured as replacement value of assets less market value of liabilities.

Question #14 of 99

Question ID: 465412

The following data pertains to an equity market index.
Last dividend (D0)

100

Forecast earnings per share

300

Current and sustainable long-term growth
rate

2.5%

Required return

7.5%

Yield on 10-year government bond

6.0%

Using the data in the table, the intrinsic price level of the equity market index is closest to:

ᅞ A) 2,929.
ᅚ B) 2,050.
ᅞ C) 2,000.


Explanation
We are provided with a constant rate of growth, so we can use the constant growth dividend discount model for equity
valuation:

Questions #15-20 of 99
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:
1. 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.
2. Look at the historical returns of a number of asset classes to act as a check on forecasts for each asset class.
3. 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.
4. 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.
5. 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.
6. 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.

Question #15 of 99

Question ID: 485070

Fellows skipped a step in his technique for producing forecasts. He forgot to:
ᅞ A) assure that the underlying data is accurate.
ᅞ B) identify where he obtained his data.
ᅚ C) identify a valuation model used in his analysis.
Explanation
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 7, LOS 16.a)

Question #16 of 99

Question ID: 485071

Fellows' advice to Canfield suggests Canfield is least likely suffering from:
ᅞ A) the prudence trap.
ᅚ B) the recallability trap.
ᅞ C) failing to use conditioning information.
Explanation
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 7, LOS 16.b)

Question #17 of 99

Question ID: 485072

Andrews most likely requested bond yields because she wanted to:
ᅞ A) gauge potential fixed-income investments.
ᅞ B) develop a shrinkage estimate.
ᅚ C) analyze stock-market valuations using the risk premium approach.
Explanation
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 7, LOS 16.c)

Question #18 of 99
Which of the following is least likely a common problem encountered in forecasting?

Question ID: 485073


ᅞ A) Data measurement errors and biases.
ᅚ B) It is difficult to use multiple regression analysis.
ᅞ C) Failing to account for conditioning information.
Explanation
There are nine problems in producing forecasts:
1. limitations to using economic data
2. data measurement error and bias
3. limitations of historical estimates
4. the use of ex post risk and return measures
5. non-repeating data patterns
6. failing to account for conditioning information

7. misinterpretations of correlations
8. psychological traps
9. 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 7,
LOS 16.b)

Question #19 of 99

Question ID: 485074

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?
ᅚ A) Initial recovery.
ᅞ B) Slowdown.
ᅞ C) Late expansion.
Explanation
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
7, LOS 16.e)

Question #20 of 99

Question ID: 485075

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

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 7, LOS 16.g)


Question #21 of 99

Question ID: 465377

Which of the following is consistent with a steeply upwardly sloping yield curve?
ᅞ A) Monetary policy is expansive while fiscal policy is restrictive.
ᅞ B) Monetary policy is restrictive and fiscal policy is restrictive.
ᅚ C) Monetary policy is expansive and fiscal policy is expansive.
Explanation
When both fiscal and monetary policies are expansive, the yield curve is sharply, upwardly sloping (i.e., short-term rates are
lower than long-term rates), and the economy is likely to expand in the future.

Question #22 of 99

Question ID: 465381

Which of the following statements least likely represents a scenario from an exogenous shock?
ᅞ 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.
ᅚ B) OPEC not being able to agree on production levels leading to increased uncertainty in
global markets and increased oil prices.
ᅞ C) 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.
Explanation
The OPEC meeting and probable outcomes could be anticipated and already factored into current oil prices leading to the
least severe outcome of the answer choices. 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.

Question #23 of 99

Question ID: 465407

Which of the following statements about the Cobb Douglas production function is least accurate? The Cobb-Douglas
production function assumes the:
ᅞ A) growth in total factor productivity (TFP) is zero when constant returns to scale
are present.
ᅞ B) output elasticities of capital and labor, α and β, sum to 1.0.


ᅚ C) growth in economic output must be less than the growth in corporate earnings.
Explanation
The Cobb-Douglas production function (CD) uses the country's labor input and capital stock to estimate the total real
economic output. The general form of the function is:

Y = AKαLβ
Y = total real economic output
A = total factor productivity (TFP)

K = capital stock
L = labor input
α = output elasticity of K (0 < α < 1)
β = output elasticity of L (α + β = 1)
An assumption of the Cobb-Douglas production function is that economic growth and growth in corporate earnings are equal.
In the short-term the two can be quite different, but over the long-term the assumption is reasonable. The Cobb-Douglas
production function also assumes constant returns to scale. Thought of as efficiency, constant returns to scale implies that
total factor productivity (TFP) remains constant (ΔTFP is zero). α and β are the output elasticities of capital and labor,
respectively. The model assumes 0 < α < 1.0 and β = (1 - α) so that the sum of α and β is 1.0.

Question #24 of 99

Question ID: 465419

Which of the following is least likely to be a bias in the top-down analysis model?
ᅞ A) Models may be incorrectly specified using the wrong variables.
ᅚ B) Individual managers tend to be more optimistic than is warranted by the model.
ᅞ C) Econometric models may be slow in capturing changes in individual factors.
Explanation
Individual managers being overly optimistic is a bias in the bottom-up approach. Individual managers tend to be overly
optimistic about their firm's future thus aggregating individual manager expectations can lead to significantly over estimating
industry expectations. Biases found in the top-down approach can occur when models are sometimes slow in capturing
structural changes to the individual factors used in the model since historical data is used. Also, the models may be incorrectly
specified since the variables used in the past may no longer be appropriate.

Question #25 of 99
A Tobin's q value for an equity market of greater than 1 can be interpreted as the:
ᅞ A) market is over-valued and will revert back to a value of 1.
ᅚ B) market is over or under-valued depending upon the equilibrium value.
ᅞ C) replacement cost of assets is over stated.

Question ID: 465428


Explanation
Tobin's q compares the current market value of a company (or equity market) to the replacement cost of its assets. If no
equilibrium value is available the theoretical value of Tobin's q is 1.0. If the current Tobin's q is above (below) 1.0 the firm's
stock (or equity market) is presumed to be overpriced (underpriced). A long run average could be used for the equilibrium
value which could be greater or less than 1. For example if the long run equilibrium value for an equity market is 1.5 and we
observe a Tobin's q for that market of 1.2 then even though Tobin's q is greater than 1 the market would still be considered
undervalued compared to the long run average equilibrium value.

Question #26 of 99

Question ID: 465415

When using dividend discount models to evaluate the sensitivity of equity market value estimates to changes in input variables,
which input variable remains constant?
ᅞ A) The number of years (N) to reach the sustainable growth rate because it is
assumed to decline in a constant linear fashion.
ᅚ B) The current dividend (D0) since it is not an estimate.
ᅞ C) The sustainable growth rate since it is assumed to remain at a constant stable rate.
Explanation
The current dividend is the only input variable that is not an estimate thus it is assumed to be constant when evaluating the
sensitivity of equity market value estimates to changes in input variables when using the H-model and constant growth
dividend discount model. The other input variables (the length of the growth decline period (N) in the H-model, the sustainable
and supernormal growth rates, and the required return) are all varied to see their impact on the intrinsic value calculated using
either model.

Question #27 of 99

Question ID: 465351

Which of the following statistical tools adjusts historical estimates using a weighted average of the historical value and an
analyst-determined value?
ᅚ A) Shrinkage estimator.
ᅞ B) Multifactor model.
ᅞ C) Time series analysis.
Explanation
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.

Question #28 of 99

Question ID: 465359

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?
ᅞ A) An algorithmic method.
ᅞ B) A market-adjusted algorithmic method.
ᅚ C) A panel method.
Explanation
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.

Question #29 of 99

Question ID: 465416

Which of the following statements most accurately describes the relationship between the intrinsic value of an equity market
index and the input variables in the H model? The intrinsic value of an index is:
ᅚ A) positively related to the growth rate and length of the period of decline but
negatively related to the required return.
ᅞ B) negatively related to the growth rate but positively related to the length of the period of
decline and required return.
ᅞ C) positively related to the growth rate and required return but negatively related to the
length of the period of decline.
Explanation
In the H-model shown below the intrinsic value of a market (P0) is positively related to: the length of the period of decline in
years (N), both the sustainable (gL) supernormal (gs) growth rates, and negatively related to the required return on equity (r).
We can see that as the required return (r) increases the denominator of the equation increases causing P0, the intrinsic value,
to decrease resulting in a negative relationship between r and the intrinsic value P0.

Question #30 of 99

Question ID: 465401

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?
ᅞ A) The relative economic strength approach.
ᅚ B) The savings-investment imbalances approach.
ᅞ C) The capital flows approach.
Explanation
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.

Question #31 of 99

Question ID: 465392

Which of the following is NOT a characteristic of economic indicators as used in economic forecasting? Economic indicators:
ᅚ A) are difficult to understand and interpret.
ᅞ B) can be adapted for specific purposes.
ᅞ C) have an effectiveness that has been verified by academic research.
Explanation
Economic indicators are actually easy to understand and interpret.

Question #32 of 99

Question ID: 465328

Which of the following regarding the formulation of capital market expectations is least accurate? An analyst should:
ᅞ A) consider the investor's tax status, allowable asset classes, and time horizon.
ᅞ B) investigate assets' historical performance and their determinants.
ᅚ C) vary their assumptions when interpreting data and drawing conclusions.
Explanation
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.

Question #33 of 99

Question ID: 465364

Which of the following regarding the use of monetary policy to stimulate growth or rein in inflation in an economy is most
accurate?
ᅞ A) Only the direction of a change in interest rates is important.
ᅚ B) Both the direction of a change in interest rates and the level of interest rates are
important.
ᅞ C) Neither the direction of a change in interest rates nor the level of interest rates are
important.
Explanation
Both the direction of a change in interest rates and the level of interest rates are important. If, for example, rates are increased
to say 4% to combat inflation but this is still low compared to the neutral rate of 6% in a country, then this rate may still be low
enough to allow growth and inflation to continue.


Question #34 of 99

Question ID: 465329

Which of the following is NOT a characteristic of a good forecast using capital market expectations? The forecasts:
ᅚ A) are subjectively formed.
ᅞ B) have a minimum amount of forecast error.
ᅞ C) are consistent with the forecasts used for other assets.
Explanation
High-quality forecasts are objectively formed. They are also consistent, unbiased, well supported, and have a minimum
amount of forecast error.

Question #35 of 99

Question ID: 465396

If a cash manager thought the economy was going to have a robust recovery, (s)he would:
ᅞ A) shift from shorter-term cash instruments to longer-term cash instruments and
from more credit worthy instruments to less credit worthy instruments.
ᅚ B) shift from longer-term cash instruments to shorter-term cash instruments and from
more credit worthy instruments to less credit worthy instruments.
ᅞ C) shift from longer-term cash instruments to shorter-term cash instruments and from
less credit worthy instruments to more credit worthy instruments.
Explanation
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.

Questions #36-41 of 99
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 × F S,FGI − 0.2 × F B,FGI + εFGI

RVCC = 0.8 × F S,VCC + 0.1 × F B,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.

Question #36 of 99

Question ID: 485084

In composing their model using the macroeconomic data, the approach of Litner and Cabell:

ᅞ A) is justified based upon the length of the data set but not by its using historical
correlations.
ᅞ B) may have problems because they are using data from too early a time only.
ᅚ C) may have problems because they are using data from too early a time and they are
assuming correlation is causation.
Explanation
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 7, LOS 16.b)

Question #37 of 99

Question ID: 485085

Using the results of the estimated factor models, the forecasted covariance of FGI and VCC would be closest to:
ᅚ A) 0.0445.


ᅞ B) 0.0488.
ᅞ C) 0.0244.
Explanation
Cov(i,j) = βi,1βj,1σ2F1 + βi,2βj,2σ2F2 + (βi,1βj,2 + βi,2βj,1)Cov(F 1,F 2)
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 7, LOS 16.c)

Question #38 of 99

Question ID: 485086

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

ᅞ A) is incorrect and Cabell is correct.
ᅚ B) is correct and Cabell is incorrect.
ᅞ C) and Cabell are both incorrect.
Explanation
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 7, LOS 16.e)

Question #39 of 99

Question ID: 465356

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:
ᅚ A) cannot predict how the target might change.
ᅞ B) would forecast an increase in the target.
ᅞ C) would forecast a decrease in the target.
Explanation
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 17.h)

Question #40 of 99

Question ID: 465357

With respect to what the current shape of the yield curve indicates:
ᅞ A) both Litner and Cabell are incorrect.
ᅚ B) both Litner and Cabell are correct.
ᅞ C) Litner is correct and Cabell is incorrect.

Explanation
If monetary policy is restrictive while fiscal policy is expansive, the yield curve will be more or less flat. (Study Session 6, LOS
17.i)


Question #41 of 99

Question ID: 465358

In their discussion of the advantages of using economic indicators:
ᅚ A) Litner is incorrect and Cabell is correct.
ᅞ B) both Litner and Cabell are correct.
ᅞ C) Litner is correct and Cabell is incorrect.
Explanation
The relationships do change over time, but the indicators can be adapted to various uses. (Study Session 6, LOS 17.n)

Question #42 of 99

Question ID: 465369

Which inflation rate would allow for the greatest consistent long term growth of equity value?
ᅞ A) 5%.
ᅞ B) 8%.
ᅚ C) 2%.
Explanation
Low inflation can be a positive for equities given that there are prospects for economic growth free of central bank
interference. Inflation rates above three percent can be negative though because it increases the likelihood that the central
bank will restrict economic growth. Declining inflation or deflation is also problematic because this usually results in declining
economic growth and asset prices. The firms most affected are those that are highly levered. They would face declining profits
yet would still be obligated to pay back the same amount in interest and principal.

Question #43 of 99

Question ID: 465413

An analyst has gathered the following data for a developed market index:

% Growth in % Growth % Growth

Output

Total Factor

in Capital

in Labor

Elasticity of

Productivity

Stock

Input

Capital (α)

1.0

1.0

1.5

0.7

Output
Elasticity of
Labor (1 −
α)
0.3

If the next expected dividend is 150 and the required equity return is 8%, the intrinsic price level of the equity index is closest
to:

ᅚ A) 2,564.
ᅞ B) 2,396.
ᅞ C) 2,620.
Explanation


Using the Cobb-Douglas production function and the data provided, the long-term sustainable growth rate in GDP is:
%ΔY = %ΔA + α(%ΔK) + (1 − α)(%ΔL) = 1.0 + 0.7(1.0) + 0.3(1.5) = 2.15%
Using the constant growth dividend discount model and the growth rate of 2.15%, the intrinsic value is estimated to be:

Question #44 of 99

Question ID: 465380

Which of the following is NOT a substantial component of the change in the long-term growth rate in an economy?
ᅞ A) Changes in spending on new capital inputs.

ᅚ B) Changes in consumer spending.
ᅞ C) Changes in employment levels.
Explanation
Although consumer spending is the largest component of GDP, it is fairly stable over time. To forecast a country's long-term
economic growth trend, the trend growth rate can be decomposed into two main components: changes in employment levels
and changes in productivity. The former component can be further broken down into population growth and the rate of labor
force participation. The productivity component can be broken down into spending on new capital inputs and total factor
productivity growth.

Question #45 of 99

Question ID: 465404

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?
ᅚ A) One-year in Country A.
ᅞ B) One-year in Country B.
ᅞ C) Six-month in Country A.
Explanation
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.

Question #46 of 99

Question ID: 465373

Calculate the short-term interest rate target given the following information.
Neutral rate

4.00%

Inflation target

2.00%

Expected Inflation

4.00%

GDP long-term trend

3.00%

Expected GDP

5.00%

ᅞ A) 8%.
ᅞ B) 5%.
ᅚ C) 6%.
Explanation

The higher than targeted growth and higher than targeted inflation argue for a targeted interest rate of 6%. This rate hike is
intended to slow down the economy and inflation.

Question #47 of 99

Question ID: 465375

Which of the following is consistent with a flat yield curve?
ᅞ A) Monetary policy is expansive while fiscal policy is restrictive.
ᅚ B) Monetary policy is restrictive while fiscal policy is expansive.
ᅞ C) Monetary policy is restrictive and fiscal policy is restrictive.
Explanation
If monetary policy is restrictive while fiscal policy is expansive, the yield curve will be flat.

Question #48 of 99

Question ID: 465368

During the initial recovery phase of the business cycle, which of the following items will be increasing?
ᅞ A) Bond yields.
ᅚ B) Stock prices.
ᅞ C) Short-term interest rates.
Explanation
Stock prices generally increase in the initial recovery phase of the business cycle as the economy goes into an expansion.
However, bond yields and short-term interest rates are still very low.


Question #49 of 99

Question ID: 465340

The use of appraisal data, relative to actual returns, results in:
ᅞ A) correlations that are biased upwards and standard deviations that are biased
downwards.
ᅚ B) correlations that are biased downwards and standard deviations that are biased
downwards.
ᅞ C) correlations that are biased upwards and standard deviations that are biased
upwards.
Explanation
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.

Question #50 of 99

Question ID: 465360

Which of the following regarding the setting of capital market expectations is least accurate?
ᅞ A) When a fairly constant set of experts is polled, this method is referred to as
panel method.
ᅚ B) Surveys of practitioners have found them to be consistently more pessimistic than that
of academics.
ᅞ C) Analysts should adjust the forecasts from quantitative models using judgment, when
appropriate.
Explanation
Studies have found that the expectations of practitioners are consistently more optimistic than that of academics.

Question #51 of 99

Question ID: 465424

The Yardeni model is best explained as:
ᅞ A) being able to value the market by applying the model as a ratio with a value
greater than 1 indicating the market is overvalued.
ᅚ B) a variation of the constant growth dividend discount model in which earnings are used
instead of dividends, the yield on A-rated corporate bonds is substituted for r the
required return on equity, and a 5 year growth forecast is substituted for the growth
rate.
ᅞ C) a variation of the constant growth dividend discount model in which earnings are used
instead of dividends.
Explanation
The Yardeni model for estimating the equilibrium earnings yield (i.e., the fair earnings yield) is based on a variation of the


constant growth dividend discount model (CGM), in which investors value total earnings rather than dividends:

We can restate the CGM to show that the earnings yield must be the difference between the required return on equity and
expected long-term growth. This is logical, since we assume the total return on equity, r, must be the sum of the earnings
yield, E1 / P0, and growth (i.e., capital gains), g:

Yardeni incorporates risk into his model by using the yield on A-rated corporate bonds, YB, as the required return on equity, r.
The difference between the yields on A-rated corporates and risk-free treasuries serves as a proxy, although most likely
understated, for the equity risk premium. Also, instead of the long-term growth assumed in the CGM, Yardeni uses a 5-year
growth forecast, LTEG, for the S&P 500. The model becomes:

The Yardeni model can be applied as a ratio:

Question #52 of 99

Question ID: 465361

Which of the following regarding the setting of capital market expectations is least accurate?
ᅞ A) Capital market expectations can also be formed using surveys.
ᅞ B) Judgment can be applied to project capital market expectations.
ᅚ C) Quantitative models should not be adjusted for an analyst's subjective opinions.
Explanation
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.

Question #53 of 99

Question ID: 465420

Which of the following statements is least characteristic of the bottom-up method of forecasting investment returns?


ᅞ A) Assessing a firm's management to determine its willingness and ability to
adopt technology to remain competitive in the market place.
ᅚ B) The analyst compares expected performance of various indices to general asset
classes.
ᅞ C) Cash flow analysis is used to determine a firm's investment potential.
Explanation
The analyst comparing the expected performance of indices to general asset classes, such as equities, bonds, and
alternatives to identify which class of assets will be expected to under- or out-perform is considered part of a macro-analysis
top-down method of forecasting.
In a bottom-up forecast, the analyst first takes a microeconomic perspective by focusing on the fundamentals of individual
firms. The analyst starts the bottom-up analysis by looking at an individual firm's product or service development relative to the
rest of the industry. The analyst should assess the firm's management and its willingness and ability to adopt the technology
necessary to grow or even maintain its standing in the industry. Given the analyst's expectations for the firm, the analyst uses
some form of cash flow analysis to determine the firm's investment potential (i.e., expected return).

Question #54 of 99

Question ID: 465397

If inflation rises, the yields for TIPS will:
ᅚ A) fall and their price will rise.
ᅞ B) rise and their price will fall.
ᅞ C) rise and their price will rise.
Explanation
If inflation starts rising, the yields for U.S. Treasury Inflation Protected Securities (TIPS) will actually fall and their prices will rise
because the demand for them increases as investors seek out their inflation protection.

Question #55 of 99

Question ID: 465398

Which of the following statements regarding TIPS is most accurate? TIPS have:
ᅞ A) inflation risk but no credit risk.
ᅚ B) no credit risk and no inflation risk.
ᅞ C) credit risk but no inflation risk.
Explanation
U.S. Treasury Inflation Protected Securities (TIPS) are both credit risk and inflation risk free.

Question #56 of 99

Question ID: 465391

Which of the following is NOT a characteristic of a checklist approach as used in economic forecasting? A checklist approach:

ᅚ A) does not allow for changes in the model over time.
ᅞ B) requires subjective judgment.
ᅞ C) may not be able to model complex relationships.
Explanation
A checklist approach actually allows for changes in the model over time.

Question #57 of 99

Question ID: 465376

Which of the following is consistent with a likely weak economy in the future?
ᅞ A) Monetary policy is expansive and fiscal policy is expansive.
ᅞ B) Monetary policy is restrictive while fiscal policy is expansive.
ᅚ C) Monetary policy is restrictive and fiscal policy is restrictive.
Explanation
When both fiscal and monetary policies are restrictive, the yield curve is downward sloping (i.e., it is inverted as short-term
rates are higher than long-term rates), and the economy is likely to contract in the future.

Question #58 of 99

Question ID: 465418

Of the following investment strategies, which one would benefit most from a bottom-up forecasting approach in predicting
equity returns?
ᅞ A) A macro hedge fund manager allocating funds among currency markets.
ᅚ B) Buying and selling individual securities to capture short-term pricing inefficiency.
ᅞ C) Allocating invested funds across various markets.
Explanation
In a bottom-up forecasting approach, the analyst first takes a microeconomic perspective by focusing on the fundamentals of

individual firms indicative of buying and selling individual securities to capture short-term pricing inefficiency.
In a top-down forecasting approach, the analyst utilizes macroeconomic factors (e.g., interest rate expectations, expected
growth in GDP) to estimate the performance of market-wide indicators, such as the S&P 500. Successive steps include
identifying sectors in the market that will perform best given market expectations.

Question #59 of 99

Question ID: 465393

Which of the following is NOT a characteristic of econometrics as used in economic forecasting? Econometrics:
ᅞ A) is better at forecasting expansions than recessions.
ᅚ B) provides a straightforward method of creating a model.
ᅞ C) can provide precise quantitative forecasts of economic conditions.


Explanation
Econometric analysis can actually be difficult and time intensive to create.

Question #60 of 99

Question ID: 465339

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?
ᅞ A) Synchronous data and downward biased correlations with equities.
ᅞ B) Asynchronous data and upward biased correlations with equities.
ᅚ C) Asynchronous data and downward biased correlations with equities.
Explanation
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.

Question #61 of 99

Question ID: 465389

Which of the following is NOT an indication of high risk in an emerging market economy?
ᅞ A) A high fiscal deficit.
ᅞ B) A GDP growth rate of 3%.
ᅚ C) A government committed to structural reform.
Explanation
If a government is supportive of structural reforms necessary for growth, then the investment environment is more hospitable.
Growth rates less than 4% may indicate that the economy is growing slower than the population, which can be problematic in
these underdeveloped countries.

Question #62 of 99
In the early expansion phase of the business cycle stock prices are:
ᅞ A) stagnant as they are in the later stages of an expansion.
ᅚ B) rising at a faster rate than they are in the later stages of an expansion.
ᅞ C) rising at a slower rate than they are in the later stages of an expansion.
Explanation

Question ID: 465399