Vignette: Ingrid Lacy, the chief investment manager (CIO) of an asset management company, is responsible for country allocation among global emerging markets. In her research, she intends to apply the neoclassical approach to growth accounting in conjunction with the H-model. Currently, she is discussing the specifics of the H-model with her assistant Jane Tally.
Ingrid states that in the long run the growth in corporate earnings and dividend cash flow should closely follow the real growth in GDP. Therefore, she assumes equal growth rates for GDP, corporate earnings, and dividend cash flow.
Jane adds that using the H-model somewhat increases the possibility of compounding the forecasting error because it involves an approximation to the true value that would be derived if a year-by-year cash flow projection is developed.
Question: Which of the following factors causes market prices of equities to vary more than the respective underlying normalized corporate earnings?
Select an Answer: macroeconomics factors government regulatory policies behavioral factors fundamental factors
Behavioral factors (cognitive and emotional) cause markets to rally or decline longer than what is justified by the purely fundamental factors. Thereby resulting in more volatile market prices of equities as compared to the respective underlying normalized corporate earnings.
Vignette: Tom Banks, the senior analyst of a consulting firm specializing in global investment analysis, is currently working on the valuation of Asian equity markets. In his research, he intends to apply the neoclassical approach to growth accounting, in conjunction with the relative value approach, to decide if current portfolio exposures to Asian equity markets are appropriate relative to the global benchmark. He is discussing the specifics of the relative value approach with his assistant Mark Adams.
Tom states that due to elevated political risk and structural macroeconomic instabilities in the region, the justified forward P/E ratios are expected to expand. Mark concludes that this will cause a significant drop in the market.
Tom is currently analyzing two countries - A and B. Country A demonstrates better international market integration and is better correlated with other equity markets. Tom believes that the better international market integration is the higher justified P/E ratio.
The government of Country B is planning to allow free cross-border investing and divesting of equities by investors outside the country. Mark concludes that such reforms would increase the justified P/E ratio.
Tom adds that there may be serious problems with the accuracy of data needed to apply the relative value approach. In developing countries in Asia, it is difficult to obtain long-dated historically consistent data. This is because these countries are experiencing fundamental governmental and structural reforms and changes. Furthermore, it is possible that the rate of growth in corporate profits diverge from the rate of growth in GDP for prolonged periods of time. Mark stated that such divergence, despite being prolonged periods of time, can be easily modeled by the neoclassical approach to growth accounting and should not be considered problematic.
Tom states that in Country C the money supply (M2) is expected to significantly outpace the rate of inflation and might cause hyperinflation in the following years. Mark adds that such developments might cause instability in the currency market as well. They wonder if it is appropriate to use the neoclassical approach to growth accounting and the relative value approach in such an environment. They are concerned that their approach might lose its precision to a significant extent.
Table 1 displays forecasted data inputs needed to apply the relative value approach.
Annualized standard deviation
Correlation with int'l. markets
Required real equity return
Question: Regarding the relative value approach, indicate how the P/E ratio is affected by an increase in the inflation-adjusted equity discount rate and the terminal real growth rate.
Lower / higher discount rate and higher / lower terminal growth rate increases / reduces the justified P/E ratio.
Question: The duration of a bond is equal to the:
Select an Answer: amount of time the bond has been outstanding. percentage change in price that corresponds to a 100 basis point change in the interest rate. number of coupon payments the bond has made. maturity of the bond.
Duration is a measure of sensitivity to interest rate changes. Therefore, duration is the percentage change in price that corresponds to a given change in interest rates.
Question: An employee has a duty of ________ to his current employer, even if he has already disclosed plans to leave within the near future.
Select an Answer: judgment loyalty prudence sagacity
Loyalty states that a departing employee is free to make preparations to go into a competitive business before terminating the relationship with the employee's current employer provided that such preparations do not breach the employee's duty of loyalty.
Question: Suppose a portfolio manager of a $100 million portfolio wishes to achieve a dollar duration of $1 million in response to a 20 basis point change in rates.
What is the target duration?
Select an Answer: 20 50 5 100
A 100 basis point change would generate a $5 million change (100/20 × $1M). Therefore, the target duration is equal to $5 million/$100 million × 100 = 5.