Economic Analysis

Question 1

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Permanent income hypothesis

Answer 1

The hypothesis that consumers’ spending behavior is largely determined by their long-run income expectations

Question 2

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Mean-Variance Optimization (MVO)

Answer 2

E(r), σ (std deviation), ρ (Correlation)

Question 3

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Challenges in Forecasting​

1. Time Lag in Data - problems in collecting, processing and distributing

Answer 3

Revisions - initial estimates may be revised

Methodology change over time (GNP -> GDP)

Re-basing index values, cannot mix data w/o adj

Question 4

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Challenges in Forecasting​

2. Transcription errors - problems in gathering data

Answer 4

Survivorship bias - data only maintain survivors (upward bias)

Appraisal/smoothed data - illiquid markets use appraisal values that do not represent mkt data (smaller correl w/ other assets). Should rescale, increasing dispersion and maintaining mean

Question 5

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Challenges in Forecasting​

3. Limitations of Historical Data

Answer 5

Regime change - changes in political, regulatory or legal env., creates non-stationarity in data (diff parts have diff underlying assumptions)

Data set size - may require long data series, but raises problems (eg. large sets may lead to spurious correl)

Ex post (actual) risk can be a biased measure of ex ante (before) risk - evaluate if past asset prices reflect the possibility of a negative event that did not occur (and remove it if it was a mispricing event); only ex ante risk is what is important

Question 6

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Challenges in Forecasting

4. Biases in Analyst Methods

Answer 6

Data mining - actively searching through data to identify a pattern

Time-period bias - selecting a specific time frame that explains a patter. Should scrutinize the variable selection process and provide the economic rationale for the variable’s usefulness

Question 7

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Challenges in Forecasting

Analyst Behaviour Traps

Answer 7

OSCAR P.

Overconfidence Trap

Status quo

Confirming evidence trap

Anchoring

Recallability

Prudence (heard)

Question 8

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Singer-Terhaar International (Equity Risk Premium)

Answer 8

1. ERP_Segmented = σ_asset * Sharpe_GIM (Er - rf / σ_GIM) + illiquidity premium
   ERP_Integration = σ_asset * ρ_asset * Sharpe_GIM (Er - rf / σ_GIM) + illiquidity premium
2. Weight risk premiums

. Degree of integration * ERP_Integration / (1 - Degree) * ERP_Segmented

3. ERP = wERP + rf

Other. Mkt Beta = (σ_i * ρ_i,GIM) / σ_GIM

Question 9

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Taylor Rule

Answer 9

Taylor Rule: r_target = r_neutral + [0.5 (GDP_expected − GDP_trend) + 0.5 (i_expected − i_target)]

Question 10

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Emerging Markets - Country Risk Analysis Techniques (for bonds downside risk protection)

Answer 10

1. Fiscal deficit/GDP > 4% concern, below 2% doing well
2.  GDP > 4% = ok
3. Current Account Deficit > 4% of GDP = problematic.
4. Debt / GDP > 70% = concern
5. Foreign currency debt / GDP > 50% = danger
6. Debt / Current accounts > 200% = concern

Question 11

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Cobb-Douglas production function (CD):

Answer 11

Y = AK^α L^β or ΔY/Y

ΔY ≅ ΔA/A + α*ΔK/K + (1−α) *ΔL/L

α = output elasticity of capital

β = output elasticity of labor

α + β = 1.0

A = Solow residual or TFP (not directly observable)

• Change due to technology; capital flows and labor mobility; trade restrictions; laws; division of labor; natural resources.

K = Capital

L = Labor

Question 12

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DDM H-model

Answer 12

High growth that linearly decays to a perpetual growth state

Question 13

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Earnings Yield

Answer 13

E1 / P0 = (ke – g) / payout

g = ROE * (1 – payout)

r = D1/P0 + g

Question 14

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Relative Valuation Models (using Earnings Yield)

Answer 14

1. Fed model: Equity Earnings Yield_n+1 vs. Bond Yield _{10-year <strong>Government</strong> Treasuries}
   
   • Includes no equity risk premium, ignores earnings growth, and compares a real variable (earnings yield) with a nominal variable (bond yield).
2. Yardeni model: addresses some of the criticisms using a corporate bond yield as a proxy for the riskiness of equities. Equity Earnings Yield_n+1 vs. Bond Yield_{10-year <strong>Corporate A rated</strong> yield} – d * (g_Long)
   
   • D is a weighting factor that depends on the mkt focus on earnings (use 0.1)
3. Cyclically adjusted P/E ratio (CAPE): Real price of the S&P 500 / moving average of past 10 years’ normalized real EPS. Mean reverting over the longer run.

Question 15

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Asset Valuation Models

Answer 15

1. Asset Valuation Models
   
   1. Tobin’s Q = (MV_equity + MV_debt) / Replacement cost of assets
   2. Equity Q = Mkt Cap Equity / (Assets at replacement cost - MV_debt)
   3. Price / Book Value

Question 16

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Bond-yield-plus-risk-premium

Answer 16

Bond-yield-plus-risk-premium = YTM_{long-term government bond} + Equity risk premium

(no inflation, illiquidity or corporate bond)

Question 17

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Grinold–Kroner: Expected Return for Equities

Answer 17

E(R) = D/P ‒ ∆S + i + g + ∆PE

E(R) = expected rate of return on equity

D/P = expected dividend yield

∆S = expected percent change in number of shares outstanding (repurchase is negative)

i = the expected inflation rate

g = the expected real total earnings growth rate (not identical to EPS growth rate in general, with changes in shares outstanding)

∆PE = per period percent change in the P/E multiple (DEIXAR NA BASE CORRETA O CRESCIMENTO)

Question 18

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Monetary / Fiscal Policies impact in Yield Curve

Answer 18