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Flashcards in Economics Deck (40):

CMA Challenges

  • 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.


Statistical Tools

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 


Time Series Variance Formula

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


Reminder to take the square root


Discounted Cash Flow Models



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


  1. Doesn't account for current market



Applying GGM to entire markets

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

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


GK Expected Income Return

(D1 / P0) - ▲S


▲S = % change in shares outstanding

Repurchase increases cash flows to investors and expected return

Issuance decreases both


Grinold and Kroner Model (GK)

r = (D1 / P0) - ▲S + i + g + ▲(P/E)


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


Financial Equilibrium Approach

Estimating the equity risk premium using;

  • Corrrelation
  • Std
  • Share ratio

If market is fully segmented, diversification is impossible


Financial Equilibrium Steps

Equity Risk Premium

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


Financial Equilibrium Formula

Beta and Covariance


(Cor)(stdi) / stdm




Note: std is whole numbers


Expected Current Yield

Expected Capital Gains Yield

Total Expected Return

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


Expected Capital Gains Yield = real growth + inflation + repricing


Total expected return = Current Yield + Capital Gains Yield


Inventory and Business Cycles

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


Business Cycle Phases

                         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


Components of GDP

GDP = C + I + G + Net exports


C = Consumer spending (stable)

I = investment (volatile)

G = Government spending

Net exports = X - M


Taylor Rule

Prescribed central bank policy rate

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

Neutral rate = real policy rate + inflation


Inflation and Asset Class Attractiveness

Inflation(exp)  Cash      Bonds     RE    Equity

At or below   Neutral    Neutral  Neutral    +  


Above exp        +              -            +             -       


Deflation            -             +            -              - 


Yield Curve/Economy with Government Policies

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



Economic Growth Trends

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



Structural Gov. Policies for L/T Growth

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


Ability to Service Debt Signs

EM Warning Sign

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%




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

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


*Constant returns to scale

*subject to diminishing returns


Total Factor Productivity (TFP) Increase With......

Increases over time with;

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



DDM for Developed and Less Devoloped Economies


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)


GGM Formula

P0 = D1 / r - g



Rearranged for required return;

r = (D1 / P0) + g


H Model Formula

       D0       *     [(1 + gL) + H(gS - gL)]

     r - gL                            


Use the real discount rate;

  • inflation rates flucuate so easier to compare
  • More stable
  • r increasing means P decreases


Justified P/E Formula

Take H Model Value / Forecasted EPS


EPS Top Down vs Bottom Up Differences


  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


Fed Model

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


Fed Model Drawbacks and Inflation


  • Ingores equity risk premium
  • Ingores earnings growth

Inflation (also a drawback):

  • EY is real
  • Treasury yield is nominal


Yardeni Model

Definition: actual EY vs theoretical (fair value) EY

     Fair Value EY: E1 / P0 = YB - d(LTEG)

     Actual EY: E1 / P0 OR stated

Note: Discount rate is the A-rated corporate bond yield 


YB= 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



Yardeni Model Interpretation & Model Inputs

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


Yardeni Model Equity Value

V0 = E1 / YB - d(LTEG)


If P0 > V0 ----- The market is overvalued

YB = 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


Yardeni Model Pros/Cons


Incorporates equity risk by using corporate BY


Equity risk premiums exceed corporate BY
Earnings estimate can be wrong
Assumes the discount rate is constant


10-Year Moving Avg P/E Ratio

Definition: compares current P/E to a moving average of P/E

Notes: moving average IS adjusted to account for inflation



  • Accounting changes can cause issues
  • Long periods of high or low P/E can persist


Tobin's Q 

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)


Equity Q

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


Monetary/Fiscal Policy


Money supply. Increasing stimulates economy


Government spending or lowering taxes stimulates economy


Bond-yield-plus-risk-premium method

 long-term government bond + the equity risk premium


Psychological Traps

  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


From Questions

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)