THROUGH 54 RELATE TO CAPITAL MARKET EXPECTATIONS. CHRIS...

Questions 49 through 54 relate to Capital Market Expectations.

Chris McCeary Case Scenario

Chris McCeary is the chief economist at Indigo Investment Management (IIM), an asset

management and financial advisory firm in USA. McCeary works at the research

department of the firm with a team of research analysts, including statisticians, portfolio

managers, financial analysts and economists. McCeary is currently performing a country

analysis of Russia and Brazil, both emerging market economies considered by IIM as

attractive inclusions to their emerging markets fund. After his comprehensive analysis of

the countries, McCeary made the following recommendations for each country:

Russia: During the past year and a half, businesses in Russia have been increasing

production and have seen a significant rise in sales and profits. They have been

building inventories to meet sales, so that, until recently, the inventories

reached a significant high level relative to Russia’s historical inventory levels.

Given such a positive outlook, I believe we should invest in cyclical stocks in

Russia, as they would gain the most from such changes.

Brazil: The inventory to sales ratio in Brazil has moved down significantly after

following a falling trend for the past fourteen months. In addition, interest rates

are low and unemployment is high in the country. I believe this is a point of

economic weakness so investing in stocks would be a bad choice.

McCeary has been assigned the task of analyzing the economic scenario of Japan, one of

the major developed economies in the world. During his analysis, McCeary discovered

that asset prices in the country have fallen considerably, as measured using consumer

price indices. Also, the interest rates in the Japanese economy lie in the range of 0.88%-

1.0%. McCeary is not sure how this scenario can affect the Japanese economy.

After completing his country analysis of Japan, McCeary met with Liz Radley, a research

analyst at IIM. During a conversation with McCeary, Radley mentioned the use of the

Taylor rule as a predictor of the central bank’s behavior in a country. She stated that since

the rule could provide a reasonably accurate description of the central bank’s stance, she

is using it to predict the optimal short-term interest rate for the U.S. over her forecast

period. Exhibit 1 presents some information she gathered over her forecast horizon.

Exhibit 1

U.S. Economic Information

The short-term interest rate when GDP

growth is on trend and inflation on target 4.5%

The current short-term interest rate 5.0%

The inflation target 3.0%

The GDP trend rate 3.75%

Inflation forecast 4.5%

Historical inflation 4.75%

GDP forecast 2.5%

As their conversation continued, McCeary made the following comments to Radley:

Statement 1: “Two years ago, the U.S. economy went through a slowdown as

unemployment increased and the economy saw a large decline in business

investment. However during the same period, the U.S. budget deficit rose

because tax revenues fell and government spending on unemployment

benefits increased. This served as a stimulus to the economy, which

caused it to revive in a year.”

Statement 2: “The fiscal and monetary policies of a government can have an effect on

the yield curve. If the both policies are expansive, the yield curve is steep.

If both are tight, the yield curve is inverted. However, if one is tight and

the other is loose, the yield curve tends to be flat.”

McCeary has invested his own portfolio in diversified Mexican stocks. However, he is

not sure how his investment would perform in the coming few years. As part of his

assessment of the Mexican economy, McCeary gathered the following information:

1.   The Mexican government has been running a budget deficit for the past few years

and the deficit has increased over the last two years.

2.   The Mexican labor market is subject to rules and regulations governing the hiring

and firing of employees.

3.   The Mexican government has reduced trade tariffs and barriers, which has

increased competition and reduced stock market valuations in the country.

In addition, as part of the country risk analysis of Mexico, McCeary gathered the

following information:

1.   The ratio of the fiscal and current account deficit to GDP has persistently been

above 4%.

2.   The ratio of debt to current account receipts is above 200% and the ratio of

reserves to short-term debt is below 100%.

McCeary will use this information to assess the risks of investing in the country’s capital

markets.

49.  With respect to his recommendations regarding Brazil and Russia, McCeary is

A.   Russia only.

B.   Both Brazil and Russia.

C.   Neither Brazil nor Russia.

50.  The economic scenario in Japan is least likely a threat to the economy because

it:

A.   threatens a recession and decreases resistance to a reduction in wages.

B.   tends to undermine debt-financed investments.

C.   negatively affects commodity-producing businesses.

51.  Using Exhibit 3, the optimal short-term interest rate in the U.S. is closest to:

A.   4.625%.

B.   4.750%.

C.   5.125%.

52.  McCeary is most accurate with respect to:

A.   Statement 1 only.

B.   Statement 2 only.

53.  Which of the above points regarding the Mexican economy most likely boosts

trend growth in the country?

A.   Point 3 only.

B.   Points 1 and 2 only.

C.   Points 2 and 3 only.

54.  Which of the above points regarding the country risk analysis of the Mexican

economy most likely indicates high risk?

A.   Point 1 only.

B.   Point 2 only.

C.   Both points 1 and 2.