60 RELATE TO OTTERBEIN FORECASTING. JIMENA MORA, CFA, AND...

Questions 55-60 relate to Otterbein forecasting.

Jimena Mora, CFA, and Jack Wieters, CFA, are economists for Otterbein Forecasting. Otterbein

provides economic consulting and forecasting services for institutional investors, medium-sized

investment banks, and corporations. In order to forecast the performance of asset classes and

formulate strategic asset allocations, Mora and Wieters are currently examining the capital

market expectations for four developed countries: Alzano, Lombardo, Bergamo, and Linden.

Wieters was hired in 2009 and Mora is his supervisor.

Mora and Wieters use the Grinold and Kroner model to forecast equity market performance.

Macroeconomic forecasts and capital market expectations for three countries are given below:

Alzano Bergamo Lombardo

Change in Correlation with World Index 7.30% 12.20% 0.30%

Change in P/E ratio 0.70% 1.10% −0.20%

Change in Shares Outstanding −0.20% 1.20% −0.80%

Dividend Yield 2.70% 0.60% 3.60%

Growth in Real Earnings 4.80% 5.70% 2.20%

Growth in Exports 3.70% 2.30% 1.70%

Growth in Imports 4.60% 7.20% 2.60%

Liquidity Risk Premium 2.00% 3.60% 0.70%

Long-Term Inflation Rate 2.80% 5.30% 1.90%

Mora is also examining the return on federal government bills and bonds of various maturities for

the country of Linden. The data are provided below:

Maturity in Years Yield

0.25 4.54

0.50 4.48

1.00 4.47

2.00 4.39

3.00 4.36

4.00 4.33

5.00 4.31

10.00 4.08

15.00 3.92

20.00 3.57

One of Otterbein Forecasting's largest clients is an institutional investor in Linden, the Balduvi

Endowment. The current and potential asset allocations for the endowment are shown below:

Current and Potential Portfolios

Asset Allocation Percentages (%)

Asset Class

Current A B C

Cash Equivalents 3 3 3 3

Government Bonds 21 22 11 34

Investment Grade Bonds 21 22 11 33

High-Yield Bonds 10 17 26 5

Non-Cyclical Stocks 25 22 31 20

Cyclical Stocks 20 14 18 5

Mora asks Wieters for his opinion on the future of the economy in Linden and the appropriate

investment for the Balduvi Endowment.

Mora has been asked by the Otterbein CEO to develop a model for explaining stock returns. In

her master's degree training, Mora was instructed that the default risk premium has predictive

power for stock returns; however, the CEO has asked her to include other macroeconomic

variables. Mora examines the following data for the capital market history of Bergamo:

1. Default risk premiums, which she measures as the difference in yields between high-yield

bonds and government bonds.

2. Maturity risk premiums, which she measures as the difference in yields between 10-year and

1-year government bonds.

3. Lagged changes in the stock market.

Mora uses these variables to explain stock returns in the following year. Using 40 years of data,

she finds the following results for the significance of the variables in explaining stock returns:

Variable

Maturity Risk

Lagged Changes in

Analysis Default Risk

Premium

the Stock Market

Correlation Significant Insignificant Significant

Regression Significant Insignificant Significant

Mora concludes from the correlation analysis that, of the three variables studied, the default risk

premium has the most predictive power for stock returns.

As the most recent hire at Otterbein Forecasting, Wieters is well versed on the latest evidence on

asset pricing and financial engineering. However, Mora suspects that his limited experience

results in erroneous forecasts.

For instance, during the credit crisis of 2007-2008, annual stock returns in Lombardo averaged -

12.6%. However, using the 80-year history of its capital market, annual stock returns in

Lombardo have averaged 13.6%. For his clients' strategic asset allocations in 2010 and onward,

Wieters projects Lombardo stock returns of 6.5%. As his supervisor, Mora questions him about

this, and she suggests that Wieters revise his projections upward.

Mora and Wieters are discussing the valuation and risk analysis of emerging market securities

and economies. In their discussion, Mora makes the following comments:

"Emerging countries are dependent on foreign financing of growth, but it is

Statement

important that a country not take on too much debt. A financial crisis can lead to

1:

currency devaluations and capital flight. Foreign debt levels greater than 50% of

GDP or debt greater than 200% of current account receipts may indicate that a

country is over-levered."

"In financial crises, emerging market debt is particularly susceptible, as currency

2:

devaluations will quickly reduce the principal and coupon value. Because most

emerging debt is denominated in a domestic currency, the emerging government

must have foreign currency reserves to defend its currency in the foreign

exchange markets."

...

Using the Grinold and Kroner model, which of the three countries has the highest expected

return for its equity market?

A) Alzano.

B) Bergamo.

C) Lombardo.

Question #56 of 60

What does the bond data predict for the future of the economy in Linden?

A) The economy is likely to expand in the future.

B) The economy is likely to contract in the future.

C) The economy is likely to experience no growth in the future.

Question #57 of 60

Using only the forecast for the Linden economy, which of the following portfolios should Wieters

recommend for the Balduvi Endowment?

A) Portfolio A.

B) Portfolio B.

C) Portfolio C.

Question #58 of 60

Which of the following psychological traps is Mora likely susceptible to in her analysis of

Bergamo stock returns?

A) Status Quo trap.

B) Recallability trap.

C) Confirming Evidence trap.

Question #59 of 60

Which of the following psychological traps is Wieters likely susceptible to in his forecast of

Lombardo stock returns?

A) Anchoring trap.

B) Status Quo trap.

C) Recallability trap.

Question #60 of 60

Regarding the statements made by Mora on the analysis of emerging market securities and

economies, are both statements correct?

A) Yes.

B) No, both statements are incorrect.

C) No, only Statement 1 is correct.