QUESTIONS 25 TO 30 RELATE TO PERFORMANCE ATTRIBUTION MINGLU LI CASE SC...

10-year AA corporate bond yield 4.4%

Type of Premium Premium

Inflation premium 0.6%

Illiquidity premium 0.9%

Equity risk premium 8.4%

After considering a number of approaches, Li and her team decided to use the bond-yield-plus-risk-

premium method. The method worked well in 2012, but a new assignment presented to Li’s team the

previous week posed a new challenge.

A new consumer credit mechanism was being tested on a small scale using a “smart phone” application

to pay for items instead of the traditional credit card. The application had proved successful in the use of

microloans in developing countries and was now being applied to a much broader consumer base. The

new challenge for Li’s team is to develop a model for the expected return for these new consumer credit

companies, called “smart credit” companies, that combine the consumer credit industry and what

traditionally was considered the telecommunications industry.

Although smart credit company returns data are sparse, a five-year monthly equally weighted index

called the Smart Credit Index (SCI) was created from the existing companies’ returns data. The number

of companies in the index at a given time varies as a result of firms failing and also combining through

time.

The SCI risk premium, equal to the SCI return less the risk-free rate, denoted as SCIRP, is used as the

dependent variable in a two-factor regression where the independent variables are index returns less

the risk-free rate for the consumer credit industry (CCIRP) and the telecommunications industry

(TELIRP). The regression results are in Exhibit 2.

Exhibit 2

Data, Statistics, and Regression Results

Index Mean Variance

SCIRP 5.4% 0.2704

CCIRP 4.6% 0.0784

TELIRP 2.8% 0.1024

Note: CCIRP and TELIRP are uncorrelated.

Regression Coefficient α β (CCIRP) β (TELIRP)

Coefficient Value: 0.011 1.020 1.045

Note: All coefficients are statistically significant at the 95% level.

Although volatility information is available from the SCI data and correspondingly for the SCIRP, Li’s

team wants to determine the statistical relationship between the SCIRP and both the consumer credit

index risk premium (CCIRP) and the telecommunications index risk premium (TELIRP) because

forecasting the CCIRP and TELIRP is much less difficult than forecasting the SCIRP. After some discussion,

the team believes that the volatility measure for the SCIRP data based on the volatility of CCIRP and

TELIRP through the regression should be adjusted to incorporate a correlation coefficient of 0.25

between the CCIRP and TELIRP. Although the two index risk premiums were uncorrelated in the past and

within the regression, Li’s team believes the two technologies will become more correlated in the

future.

Li’s team also examined survey data within the consumer credit and telecommunications industries

during the same time period for which the actual data was collected. They found that projections in the

surveys of the CCI and TELI tended to be more volatile than the actual data. Li’s team has decided not to

make any adjustments, however, because a definitive procedure could not be determined.

Given the effect of short-term interest rates on consumer credit, Li’s team then decides to determine

where the short-term interest rate is expected to be in the future. The Central Bank recently issued a

statement that 2.5% appeared to be the appropriate rate assuming no other factors. Li’s team then

considers potential factors that may make the Central Bank behave differently from the 2.5% rate in the

statement (see Exhibit 3).

Exhibit 3

Central Bank Factors

GDP growth forecast 2.0%

GDP growth trend 1.0%

Inflation forecast 1.5%

Inflation target 3.5%

Earnings growth forecast 4.0%

Earnings growth trend 2.0%

Based on Taylor’s rule with an assumption of equal weights applied to forecast versus trend measures,

the short-term rate is expected to increase from the current 1.23% and the yield curve is expected to

flatten.

For further insight, Li decides to consult an in-house expert on central banking, Randy Tolliver. Tolliver

states that a flat yield curve is consistent with tight monetary and tight fiscal policies.