9. The discrepancy in the bond’s price noted by Chan is most likely due to:
A. the credit risk.
B. inflation uncertainty.
C. price risk.
The following information relates to questions 10 - 12.
Sandy Murray, a senior credit analyst at HCR, a global investment firm, evaluates three bonds
from three different sectors in order to execute a short position for the firm’s fixed-income fund.
Murray reviews HCR’s economic outlook, which forecasts the GDP growth rate to be weaker
than expected and more volatile. All three bonds mature in five years and are presented in
Exhibit 1.
Exhibit 1: Credit Market Outlook
Spread to
Credit
Economic
Debt/Capital Enterprise
Value/EBITDA
Treasuries(bps)
Sector
Rating
Bond 1 Food 30% 8 200 A2
Household &
Bond 2
Personal 48% 7 240 Baa2
Products
Bond 3 Automobiles 44% 7.6 210 Baa1
Connie Li, a quantitative analyst at the firm, is developing a model that will use economic inputs
to provide an equity rotation strategy for equity funds. Li also decides to incorporate a target
equity risk premium into the model. She makes the following notes:
Ob Note I. The equity premium should be positive and given the economic outlook quite large.
O Note II. The type of product sold or service provided by a company will impact earnings and
equity performance.
O Note III. Equities demand a lower risk premium because of better consumption-hedging
properties than investment grade fixed income securities.
Li’s equity rotation model can help portfolio managers rotate from small- to large-cap stocks and
growth to value stocks. The model will assist the portfolio managers to take targeted sector
positions to enhance returns relative to the broader equity market. As Li finalizes the model she
backtests it over previous economic cycles to find out potential errors that would need correction
or modification. She notices the following results given by the model in the aftermath of
recessions:
I. Rotates from consumer staple to consumer discretionary stocks.
II. Rotates from growth stocks into value stocks.
III. Rotates from small-cap stocks to large-cap stocks
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