Economics

Question 1

CMA Challenges

Answer 1

• Data is reported with a lag and subject to revision
• Data is subject to biases and errors
  
  • transcription errors
  • survivorship bias
  • smoothed (appraised) data estimates (risk is understated)
• Economic conditions change
  
  • regime change leading to nonstationary issues
• Analyst bias in selective data mining or selection of time periods to examine.

Question 2

Statistical Tools

Answer 2

Definition: Using historical data to develop statistics.

• Arith is used for single periods, geo for multiple
• Applying shrinkage (combining historically with model estimates)
• Using time series models to estimate variance
• Using multifactor models

Question 3

Time Series Variance Formula

Answer 3

Variance² = weight(std past²) + weight(residual error²)

Reminder to take the square root

Question 4

Discounted Cash Flow Models

Advantages/Disadvantages

Answer 4

Advantages

1. Based on future cash flows
2. Ability to back out a required return

Disadvantages

1. Doesn’t account for current market

Question 5

Applying GGM to entire markets

Answer 5

Growth: nominal growth in GDP (real GDP + inflation)

Excess Corporate Growth: Adjusting for differences in GDP and equity index

Question 6

GK Expected Income Return

Answer 6

(D₁ / P₀₎ - ▲S

▲S = % change in shares outstanding

Repurchase increases cash flows to investors and expected return

Issuance decreases both

Question 7

Grinold and Kroner Model (GK)

Answer 7

r = (D₁ / P₀) - ▲S + i + g + ▲(P/E)

OR

r = exp(income return) + exp(nominal earnings) + exp(repricing)

• exp(income return) = (D₁ / P₀) - ▲S
• exp(nominal earnings) = i + g
• exp(repricing) = ▲(P/E)
• • ▲S =% change in shares outstanding
    
    • ▲(P/E) = % change in the P/E ratio

Question 8

Financial Equilibrium Approach

Answer 8

Estimating the equity risk premium using;

• Corrrelation
• Std
• Share ratio

If market is fully segmented, diversification is impossible

Question 9

Financial Equilibrium Steps

Equity Risk Premium

Answer 9

Step 1: Equity premium integrated = (cor)(std)(sharpe)
Equity premium segmented = (std)(sharpe)

*Make sure to add any illiquid premiums

• *Step 2:** Take the weighted average of integrated/segmented
• *Step 3:** Add the risk-free rate to both intregrated/segmented

Question 10

Financial Equilibrium Formula

Beta and Covariance

Answer 10

Beta

(Cor)(std_i) / std_m

Covariance

(B₁)(B₂)(std_m)²

Note: std is whole numbers

Question 11

Expected Current Yield

Expected Capital Gains Yield

Total Expected Return

Answer 11

Expected Current Yield (income) = dividend yield + repurchase yield

Expected Capital Gains Yield = real growth + inflation + repricing

Total expected return = Current Yield + Capital Gains Yield

Question 12

Inventory and Business Cycles

Answer 12

Inventory Cycle

Last 2-4 years
Measued with inventory to sales ratio (I/S)

If I/S is going up due to I GOOD SIGN

If I/S is going up due to S BAD SIGN

Business Cycle

9-11 years
5 phases

Question 13

Business Cycle Phases

Answer 13

Inflation Interest Rates Confidence & Stocks

Initial Recovery Falling Falling Rising

Early Upswing Falling Rising Rising

Late Upswing Rising Rising Peak

Slowdown Rising Peak Falling

Recession Peak Falling Falling then Rising

Question 14

Components of GDP

Answer 14

GDP = C + I + G + Net exports

C = Consumer spending (stable)

I = investment (volatile)

G = Government spending

Net exports = X - M

Question 15

Taylor Rule

Answer 15

Prescribed central bank policy rate

real policy rate + inflation + .5(expInflation - target inflation) + .5(expGDP - trendGDP)

Neutral rate = real policy rate + inflation

Question 16

Inflation and Asset Class Attractiveness

Answer 16

Inflation(exp) Cash Bonds RE Equity

At or below Neutral Neutral Neutral +

Above exp + - + -

Deflation - + - -

Question 17

Yield Curve/Economy with Government Policies

Answer 17

• *Monetary/Fiscal Policy Effects**
• *Yield Curve Economy**

E / E Steep Grow
E / R Steep Uncertain
R / E Flat Uncertain
R/R Inverted Contract

E = Expansion

R = Restrictive

Question 18

Economic Growth Trends

Answer 18

Two main components:

1. Changes in employment levels

• Population growth
• Rate of labor force participation

2. Changes in productivity

• Spending on new capital inputs
• Total factor productivity growth

Question 19

Structural Gov. Policies for L/T Growth

Answer 19

1. Sound fiscal policy
2. Sound tax policies
3. minimal government interfrence with free markets
4. Facilitate competition
5. Develop infrastructure and human capital

Question 20

Ability to Service Debt Signs

EM Warning Sign

Answer 20

Ability to Service Debt Lower If:

1. Current account deficit > 4% of GDP
2. Foreign Debt/GDP > 50%
3. Foreign currency reserves/ST debt < 100%
4. Government deficit/GDP ratio > 4%

EM Warning Sign:

• Growth < 4%

Question 21

Cobb-Douglas

Answer 21

Real GDP = TFP + weight(Capital) + weight(Labor)

Slow Residual (TFP) = Real GDP - weight(Capital) - weight(Labor)

*Constant returns to scale

*subject to diminishing returns

Question 22

Total Factor Productivity (TFP) Increase With……

Answer 22

Increases over time with;

• Improving technology
• Discovering natural resources
• Fewer trade restrictions
• Fewer restrictions on capital flows and labor mobility

Question 23

DDM for Developed and Less Devoloped Economies

Answer 23

Developed

Stable dividends, growth, and risk
Should use GGM

Less Developed

Economic data less available and not reliable
Corporate cash/dividend growth less direct
Significant changes in annual growth
Uses H-Model (2 stage)

Question 24

GGM Formula

Answer 24

P₀ = D₁ / r - g

Rearranged for required return;

r = (D₁ / P₀) + g

Question 25

H Model Formula

Answer 25

_D₀ \* [(1 + g__L_) + H(g__S _- g__L_)]_ r - g_L **Use the real discount rate;** * inflation rates flucuate so easier to compare * More stable * r increasing means P decreases

Question 26

Justified P/E Formula

Answer 26

Take H Model Value / Forecasted EPS

Question 27

EPS Top Down vs Bottom Up Differences

Answer 27

1. Top down based on historical relationships 1. Slow to reflect changes 2. Bottom up are overly emotional 1. Too optimisic in expansion 2. too pessimistic in recession

Question 28

Fed Model

Answer 28

**Definition:** Yield on S&P should be same as l/t treasuries **Formula:** S&P EY / 10-year treasury _S&P EY_ = expected operating earnings / current price of S&P **Interpretation:** S&P yield \> treasury = equities are undervalued

Question 29

Fed Model Drawbacks and Inflation

Answer 29

**Drawbacks:** * Ingores equity risk premium * Ingores earnings growth **_Inflation (also a drawback):_** * EY is real * Treasury yield is nominal

Question 30

Yardeni Model

Answer 30

**Definition:** actual EY vs theoretical (fair value) EY **Fair Value EY:** E₁ / P₀ = Y_B - d(LTEG) **Actual EY:** E₁ / P₀ OR stated **Note:** _Discount rate_ is the A-rated corporate bond yield Example Y_B= 6.49, LTEG = 11.95, d = 0.05, S&P EY = 5.5% 0.0648 - 0.05(0.1195) = 5.89. Higher than 5.5 so its overvalued

Question 31

Yardeni Model Interpretation & Model Inputs

Answer 31

If actual EY \< fair value: Actual EY is too low (stocks are too high) If actual EY \> fair value: Actual EY is too high (stocks are too low) YB - Yield on A-rated corporate bonds d = weighting factor (typically 0.1) LTEG = 5 year growth forecast

Question 32

Yardeni Model Equity Value

Answer 32

V₀ = E₁ / Y_B - d(LTEG) If P₀ \> V₀ ----- The market is overvalued Example Y_B = 6.32, LTEG = 11.5%, d = 0.10 When would equities be overvalued? 0.0632 - 0.10(0.115) = 0.0515 1/0.0517 = 19.3, So Anything over 19.3 is overvalued

Question 33

Yardeni Model Pros/Cons

Answer 33

**_Pros_** Incorporates equity risk by using corporate BY **_Cons_** Equity risk premiums exceed corporate BY Earnings estimate can be wrong Assumes the discount rate is constant

Question 34

10-Year Moving Avg P/E Ratio

Answer 34

**Definition:** compares current P/E to a moving average of P/E **Notes:** moving average **_IS_** adjusted to account for inflation **Drawbacks:** * Accounting changes can cause issues * Long periods of high or low P/E can persist

Question 35

Tobin's Q

Answer 35

**Tobin's Q:** Compares the current market value of company to replacement cost of assets Q = _MV of debt + equity_ replacement cost If Q \> 1, equity is overvalued If Q \< 1, equity is undervalued MUST be compared to an equilibrium value (otherwise you dont know)

Question 36

Equity Q

Answer 36

**Equity Q:** Compares the current market value of equity to replacement cost Q = _MV of equity_ replacement cost of assets - liabilities If Q \> 1, equity is overvalued If Q \< 1, equity is undervalued

Question 37

Monetary/Fiscal Policy

Answer 37

**_Montetary_** Money supply. Increasing stimulates economy **_Fiscal_** Government spending or lowering taxes stimulates economy

Question 38

Bond-yield-plus-risk-premium method

Answer 38

long-term government bond + the equity risk premium

Question 39

Psychological Traps

Answer 39

1. Prudence Trap: over conservative 2. Recallability Trap: Easiert to remember(event in 2008) 3. Ex post risk a biased measure of ex ante risk (Survey) From Behavioral Finance: 1. Achoring Trap 2. Status Quo Trap 3. Confirming Evidence 4. Overconfidence Trap

Question 40

From Questions

Answer 40

**Output gap:** difference between actual GDP and the l/t trend Increase with inflation lowers **Permanent Income Hypthesis:** spending behavior based on l/t income expectations (s/t events will not affect spending habits)