S6 1 Answers

Schweser Printable Answers - S6-1

Test ID#: 5

Question 1 - #91534

Which of the following is consistent with a steeply upwardly sloping yield curve?

Your answer: C was correct!

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.

This question tested from Session 6, Reading 18, LOS i.

Question 2 - #91940

Which of the following is consistent with a flat yield curve?

Your answer: B was incorrect. The correct answer was C) Monetary policy is restrictive while fiscal policy is expansive.

If monetary policy is restrictive while fiscal policy is expansive, the yield curve will be flat.


Question 3 - #92537

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?


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.

This question tested from Session 6, Reading 18, LOS d.

Question 4 - #92637

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A) Monetary policy is expansive while fiscal policy is restrictive.

B) Monetary policy is restrictive and fiscal policy is restrictive.

C) Monetary policy is expansive and fiscal policy is expansive.

A) Monetary policy is restrictive and fiscal policy is restrictive.

B) Monetary policy is expansive while fiscal policy is restrictive.

C) Monetary policy is restrictive while fiscal policy is expansive.

A) An algorithmic method.

B) A market-adjusted algorithmic method.

C) A panel method.

Page 1 of 31Printable Exams

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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?

Your answer: B was incorrect. The correct answer was C) One-year in Country A.

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.

This question tested from Session 6, Reading 18, LOS r.

Question 5 - #92204

Which of the following is NOT an input to the Taylor rule?


The Taylor rule determines the target interest rate using the neutral rate, expected GDP relative to its long-term trend, and expected inflation relative to its targeted amount.

This question tested from Session 6, Reading 18, LOS h.

Question 6 - #92161

A return index that tracks the NASDAQ stock market index can be subject to:

Your answer: B was correct!

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.

This question tested from Session 6, Reading 18, LOS b.

A) Six-month in Country A.

B) One-year in Country B.

C) One-year in Country A.

A) The expected GDP.

B) The neutral rate.

C) The discount rate.

A) survivorship bias and hence downward biased returns.

B) survivorship bias and hence upward biased returns.

C) backfill bias and hence upward biased returns.



Question 7 - #92344

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抯 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.

Part 1) Fellows skipped a step in his technique for producing forecasts. He forgot to:

Your answer: A was incorrect. The correct answer was B) identify a valuation model used in his analysis.

A) identify where he obtained his data.

B) identify a valuation model used in his analysis.

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)

This question tested from Session 6, Reading 18, LOS a.

















Part 2) Fellows' advice to Canfield suggests Canfield is least likely suffering from:



Your answer: B was incorrect. The correct answer was C) the recallability trap.

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)
















A) the prudence trap.

B) failing to use conditioning information.

C) the recallability trap.





Part 3) Andrews most likely requested bond yields because she wanted to:

Your answer: C was incorrect. The correct answer was B) analyze stock-market valuations using the risk premium approach.

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)














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'

A) develop a shrinkage estimate.

B) analyze stock-market valuations using the risk premium approach.

C) gauge potential fixed-income investments.



interest in a limited partnership that develops and manages real estate, and invest that money in high-yield bonds. Canfield's reasoning is threefold:




Part 4) Which of the following is least likely a common problem encountered in forecasting?


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 6, LOS 18.b)









A) Data measurement errors and biases.

B) It is difficult to use multiple regression analysis.

C) Failing to account for conditioning information.












Part 5) 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?

Your answer: B was incorrect. The correct answer was 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)






A) Slowdown.

B) Late expansion.

C) Initial recovery.















Part 6) Which of the following is least accurate regarding inflation?

Your answer: B was incorrect. The correct answer was A) 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)


Question 8 - #92621

Which of the following would indicate the greatest stimulation of economic growth?

A) Low inflation affects the return on cash instruments.

B) Declining inflation results in declining economic growth and asset prices.

C) Highly levered firms are most affected by declining inflation rates.

A) Tax receipts increase due to changes in the economy.

B) Tax receipts decline due to a new government policy.



Your answer: A was incorrect. The correct answer was B) Tax receipts decline due to a new government policy.

Only changes in the deficit directed by government policy will influence growth. A tax cut, which would result in lower tax receipts over the short-term, would stimulate the economy. Changes in the deficit that occur naturally over the course of the business cycle are not stimulative or restrictive. In an expanding economy, deficits will decline because tax receipts increase and disbursements to the unemployed decrease. The opposite occurs during a recession.

This question tested from Session 6, Reading 18, LOS e.

Question 9 - #92786

Which of the following is NOT an indication of high risk in an emerging market economy?

Your answer: A was incorrect. The correct answer was C) A government committed to structural reform.

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.

This question tested from Session 6, Reading 18, LOS m.

Question 10 - #92350

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?

Your answer: A was correct!

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.



If a cash manager thought the economy was going to have a robust recovery, (s)he would:

C) Tax receipts increase due to a new government policy.

A) A GDP growth rate of 3%.

B) A high fiscal deficit.

C) A government committed to structural reform.

A) Bowden is performing beta research and Weatherford is performing alpha research.

B) Bowden is performing alpha research and Weatherford is performing beta research.

C) Bowden is performing beta research and Weatherford is performing beta research.

A) shift from shorter-term cash instruments to longer-term cash instruments and from more credit



Your answer: C was incorrect. The correct answer was B) shift from longer-term cash instruments to shorter-term cash instruments and from more credit worthy instruments to less credit worthy instruments.

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.

This question tested from Session 6, Reading 18, LOS o.


Which of the following regarding the use of monetary policy to stimulate growth or rein in inflation in an economy is most accurate?


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.



Which of the following statements regarding TIPS is most accurate? TIPS have:

Your answer: C was incorrect. The correct answer was B) no credit risk and no inflation risk.

U.S. Treasury Inflation Protected Securities (TIPS) are both credit risk and inflation risk free.

This question tested from Session 6, Reading 18, LOS p.


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

worthy instruments to less credit worthy instruments.

B) shift from longer-term cash instruments to shorter-term cash instruments and from more credit worthy instruments to less credit worthy instruments.

C) shift from longer-term cash instruments to shorter-term cash instruments and from less credit worthy instruments to more credit worthy instruments.

A) Neither the direction of a change in interest rates nor the level of interest rates are important.

B) Both the direction of a change in interest rates and the level of interest rates are important.

C) Only the direction of a change in interest rates is important.

A) inflation risk but no credit risk.

B) no credit risk and no inflation risk.

C) credit risk but no inflation risk.

A) Early expansion.

B) Slowdown.



Your answer: B was incorrect. The correct answer was C) Initial recovery.

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.



Which of the following is NOT indicative of low risk in an emerging market economy?

Your answer: B was incorrect. The correct answer was C) A foreign debt level that is 75% of GDP.

Foreign debt levels greater than 50% of GDP indicate that the country may be overlevered. Debt levels greater than 200% of the current account receipts also indicate high risk. Current account deficits (roughly speaking, imports are greater than exports) greater than 4% of GDP can be problematic because the deficit must be financed through external borrowing. High risk is also indicated when foreign exchange reserves are less than the short-term debt that must be paid off in one year.



Which of the following is NOT a characteristic of economic indicators as used in economic forecasting? Economic indicators:


Economic indicators are actually easy to understand and interpret.

This question tested from Session 6, Reading 18, LOS n.


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

C) Initial recovery.

A) Foreign exchange reserves are twice that of the short-term debt.

B) A current account deficit that is 2% of GDP.

C) A foreign debt level that is 75% of GDP.

A) can be adapted for specific purposes.

B) have an effectiveness that has been verified by academic research.

C) are difficult to understand and interpret.

Neutral rate 4.00%

Inflation target 2.00%

Expected Inflation 5.00%

GDP long-term trend 3.00%

Expected GDP 1.00%




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.



Which of the following statements regarding spending and the business cycle is least accurate?


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.

This question tested from Session 6, Reading 18, LOS g.


Which of the following is NOT a governmental structural policy that would promote the long-term growth in an economy?

Your answer: C was incorrect. The correct answer was A) A redistributive tax system.

When wealth is redistributed through the government抯 tax policy, economic inefficiency is created. Tax policies should promote economic growth as much as possible.

This question tested from Session 6, Reading 18, LOS j.


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

A) 6.5%.

B) 4.5%.

C) 5.0%.

A) The inventory cycle is shorter than the business cycle.

B) As a percentage of GDP, consumer spending is much larger than business spending.

C) Business spending is less volatile than consumer spending.

A) A redistributive tax system.

B) A promotion of competition.

C) Minimal government interference in the economy.



Your answer: A was incorrect. The correct answer was C) An increase in short-term interest rates may increase or decrease the value of the domestic currency.

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.

This question tested from Session 6, Reading 18, LOS q.


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?

Your answer: B was incorrect. The correct answer was C) 9.8%.

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

This question tested from Session 6, Reading 18, LOS c.


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


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.



Which of the following statements regarding emerging market government debt is most accurate? Emerging market government debt is usually denominated in:

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.

A) 8.6%.

B) 11.0%.

C) 9.8%.

A) Multifactor model.

B) Time series analysis.

C) Shrinkage estimator.

A) a non-domestic currency which makes them less credit risky.



Your answer: A was incorrect. The correct answer was B) a non-domestic currency which makes them more credit risky.

The key difference between developed country government bonds and emerging market government bonds is that most emerging debt is denominated in a non-domestic currency (e.g., dollars, euros, etc.). The emerging government must obtain a hard currency to pay back the principal and interest. The default risk for emerging market debt is thus much higher.

This question tested from Session 6, Reading 18, LOS o.


Which of the following is NOT a characteristic of econometrics as used in economic forecasting? Econometrics:

Your answer: C was incorrect. The correct answer was B) provides a straightforward method of creating a model.

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


Question 25 - #138164

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

Your answer: B was incorrect. The correct answer was C) OPEC not being able to agree on production levels leading to increased uncertainty in global markets and increased oil prices.

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.

This question tested from Session 6, Reading 18, LOS k.


B) a non-domestic currency which makes them more credit risky.

C) the domestic currency which makes them more credit risky.

A) can provide precise quantitative forecasts of economic conditions.

B) provides a straightforward method of creating a model.

C) is better at forecasting expansions than recessions.

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抯 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.



If population growth is expected to grow by 3%, labor force participation is expected to grow by 0.25%, spending on new capital inputs is projected to grow at 2.75% and total factor productivity will grow by 0.75%. What is the long-term projected growth rate?


The sum of the components is 3% + 0.25% + 2.75% + 0.75% = 6.75%, so the economy is projected to grow by this amount.



In the early expansion phase of the business cycle stock prices are:


In the early expansion phase of the business cycle, stock prices are increasing. This is due to the fact that sales are increasing but inputs costs will be fairly stable. Labor will not ask for wage increases because unemployment is still high. Idle plant and equipment will be pushed into service at little cost. Furthermore, firms usually emerge from recession leaner because they have shed their wasteful projects and excessive spending. Later on in the expansion, the growth in earnings and stock returns slows because input costs start to increase. Interest rates will also increase during late expansion, which is a further negative for stock valuation.



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?

Your answer: C was incorrect. The correct answer was A) The savings-investment imbalances approach.

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抯 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.


A) 5.75%.

B) 6.00%.

C) 6.75%.

A) rising at a faster rate than they are in the later stages of an expansion.

B) stagnant as they are in the later stages of an expansion.

C) rising at a slower rate than they are in the later stages of an expansion.

A) The savings-investment imbalances approach.

B) The capital flows approach.

C) The relative economic strength approach.




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. Thepurpose of the newsletter is to help TTI抯 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 揝� and a world bond index 揃� 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抯 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抯 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抯 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.

Part 1) 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.




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)












Part 2) Using the results of the estimated factor models, the forecasted covariance of FGI and VCC would be closest



to:

Your answer: C was incorrect. The correct answer was A) 0.0445.

Cov(i,j) = βi,1βj,1σ2F1 + βi,2βj,2σ

2F2 + (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)











A) 0.0445.

B) 0.0244.

C) 0.0488.




Part 3) With respect to their comments concerning the relative volatility and size of business spending with respect to consumer spending Litner:


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)










Litner and Cabell discuss the use of economic indicators that are available for governments and international

A) is correct and Cabell is incorrect.

B) and Cabell are both incorrect.

C) is incorrect and Cabell is correct.



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.


Part 4) 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:


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)









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抯 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抯 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

A) cannot predict how the target might change.

B) would forecast an increase in the target.

C) would forecast a decrease in the target.



change, if any, in the central bank抯 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.



Part 5) With respect to what the current shape of the yield curve indicates:

Your answer: C was incorrect. The correct answer was B) both Litner and Cabell are correct.

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)









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

A) Litner is correct and Cabell is incorrect.

B) both Litner and Cabell are correct.

C) both Litner and Cabell are incorrect.



the Fed抯 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抯 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抯 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.



Part 6) In their discussion of the advantages of using economic indicators:


The relationships do change over time, but the indicators can be adapted to various uses. (Study Session 6, LOS 18.n)



Which phase of the business cycle is characterized by rising stock prices but increased investor nervousness?


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.

This question tested from Session 6, Reading 18, LOS f.


Which of the following is NOT a substantial component of the change in the long-term growth rate in an economy?

A) Litner is correct and Cabell is incorrect.

B) both Litner and Cabell are correct.

C) Litner is incorrect and Cabell is correct.

A) Initial recovery.

B) Slowdown.

C) Late expansion.

A) Changes in consumer spending.



Your answer: C was incorrect. The correct answer was A) Changes in consumer spending.

Although consumer spending is the largest component of GDP, it is fairly stable over time. To forecast a country抯 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.



If inflation rises, the yields for TIPS will:

Your answer: C was incorrect. The correct answer was B) fall and their price will rise.

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.



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?


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抯 return. When measured against equity returns with readily available daily data, the real estate asset standard deviation and correlation with equity is artificially low.



Which of the following is consistent with a likely weak economy in the future?

B) Changes in employment levels.

C) Changes in spending on new capital inputs.

A) rise and their price will fall.

B) fall and their price will rise.

C) rise and their price will rise.

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.

A) Monetary policy is restrictive while fiscal policy is expansive.




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.



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

Your answer: C was incorrect. The correct answer was A) correlations that are biased downwards 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.



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?

Your answer: C was incorrect. The correct answer was B) Japanese stocks.

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.



Which of the following would indicate that a country is less affected by global events? The country is:

B) Monetary policy is expansive and fiscal policy is expansive.

C) Monetary policy is restrictive and fiscal policy is restrictive.

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

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

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

A) Japanese bonds.

B) Japanese stocks.

C) U.S. bonds.

A) small and has an undiversified economy.

B) large and has a diversified economy.

C) small and has a diversified economy.



Your answer: C was incorrect. The correct answer was B) large and has a diversified economy.

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

This question tested from Session 6, Reading 18, LOS l.


Which of the following regarding the setting of capital market expectations is least accurate?

Your answer: C was incorrect. The correct answer was B) Quantitative models should not be adjusted for an analyst抯 subjective opinions.

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.

This question tested from Session 6, Reading 18, LOS d.


Suppose that Government A decreased the tariff on foreign goods and that Government B has moved to a lower marginal tax rate. Analyzing the effects on the long-term growth rate in the economy, which of the following would be most accurate?

Your answer: C was incorrect. The correct answer was A) Government A抯 growth rate will increase and Government B抯 growth rate will increase.

If the government decreases the tariff on foreign goods, competition should increase, increasing economic efficiency, and the long-term growth rate. The same is true of a cut in the tax rate (i.e., the long-term growth should increase).



Which of the following approaches to forecasting currencies states that long-term investors will affect the values of currencies?


The capital flows approach states that long-term capital flows will flow to where the best opportunities are,

A) Judgment can be applied to project capital market expectations.

B) Quantitative models should not be adjusted for an analyst抯 subjective opinions.

C) Capital market expectations can also be formed using surveys.

A) Government A抯 growth rate will increase and Government B抯 growth rate will increase.

B) Government A抯 growth rate will decrease and Government B抯 growth rate will decrease.

C) Government A抯 growth rate will decrease and Government B抯 growth rate will increase.

A) The PPP.

B) The savings-investment imbalances approach.

C) The capital flows approach.



thus increasing that country抯 currency value.



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

Your answer: C was incorrect. The correct answer was B) Early expansion.

A savings deficit exists when investment is greater than domestic savings. To compensate for a savings deficit, a country抯 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.



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?


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:

A) Late recession.

B) Early expansion.

C) Slowdown.

Sharpe ratio of the global portfolio牋� 0.29

Standard deviation of the global portfolio牋� 8.00%

Risk-free rate of return牋� 4.00%

Degree of market integration for Market A牋� 80%

Degree of market integration for Market B牋� 65%

Standard deviation of Market A牋� 18.00%

Standard deviation of Market B牋� 27.00%

Correlation of Market A with global portfolio牋� 0.86

Correlation of Market B with global portfolio牋� 0.61

Estimated illiquidity premium for A牋� 0.00%

Estimated illiquidity premium for B牋 2.50%

A) 8.35%.

B) 9.85%.

C) 12.35%.



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:



An analyst believes that a recession is likely to develop that will affect many of the world economies. She believes that Country A抯 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:

Your answer: C was incorrect. The correct answer was B) small country and its GDP should be forecast using an econometric approach.

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.



Which of the following statements regarding global economies is most accurate?

A) large country and its GDP should be forecast using an econometric approach.

B) small country and its GDP should be forecast using an econometric approach.

C) small country and its GDP should be forecast using a checklist approach.

A) Developed economies are perfectly integrated but not emerging countries.

B) Neither emerging nor developed country economies are perfectly integrated.



Your answer: C was incorrect. The correct answer was B) Neither emerging nor developed country economies are perfectly integrated.

Emerging market economies are noted for the fact that they are segmented (i.e., not integrated). Even among developed countries, economies are not perfectly integrated. For example, the Federal Reserve in the U.S. and the European Central Bank will respond to local effects in their economies, thus creating differences in U.S. and European economic growth.



Which inflation rate would allow for the greatest consistent long term growth of equity value?

Your answer: C was incorrect. The correct answer was A) 2%.

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.

This question tested from Session 6, Reading 18, LOS g.


Which of the following statements regarding risk in emerging market economies is least accurate?

Your answer: C was incorrect. The correct answer was B) The economies are often heavily dependent on consumer durables.

Small economies are often heavily dependent on the sale of commodities and their undiversified nature makes them susceptible to volatile capital flows and economic crises.



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

C) Both emerging and developed country economies are perfectly integrated.

A) 2%.

B) 8%.

C) 5%.

A) Equity investors should focus on growth prospects and risk.

B) The economies are often heavily dependent on consumer durables.

C) Their undiversified nature makes them susceptible to volatile capital flows and economic crises.

A) does not allow for changes in the model over time.

B) may not be able to model complex relationships.



Your answer: C was incorrect. The correct answer was A) does not allow for changes in the model over time.

A checklist approach actually allows for changes in the model over time.



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


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.



Which of the following would be consistent with Country A having higher real interest rates than Country B?

Your answer: C was incorrect. The correct answer was A) Country A has a tighter monetary policy and a faster growing economy.

Countries with a tighter monetary policy and stronger economic growth will see higher currency values. In fact,in the early 1980s, the U.S. had high real and nominal interest rates due to a tight monetary policy, robust economy, and an increasing budget deficit. This resulted in a higher value for the dollar.



Which asset would perform the worst during deflationary periods?

C) requires subjective judgment.

Neutral rate 4.00%

Inflation target 2.00%

Expected Inflation 4.00%

GDP long-term trend 3.00%

Expected GDP 5.00%

A) 8%.

B) 5%.

C) 6%.

A) Country A has a tighter monetary policy and a faster growing economy.

B) Country A has a looser monetary policy and a faster growing economy.

C) Country A has a tighter monetary policy and a slower growing economy.



Your answer: C was incorrect. The correct answer was A) Real estate financed with debt.

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抯 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.

This question tested from Session 6, Reading 18, LOS f.

©2011 Kaplan Schweser. All Rights Reserved.

A) Real estate financed with debt.

B) Real estate wholly owned.

C) Corporate bonds.

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