Questions 13-18 relate to Monica Garza.
Monica Garza is a portfolio manager for Southwood Group, a large investment management firm,
where she is in charge of economic and capital market forecasting. Brett Crosby, director of
research at Southwood, has asked Garza to assist him in identifying the forecasting approach
that would best suit an equity long-short hedge fund the company would like to open. The fund
will purchase securities from its investment universe that are considered to have the highest
forecasted alphas and sell short securities with negative forecasted alphas. The overall long-
short exposure will vary based on the number of securities with positive and negative forecasted
alphas.
After reviewing the forecasting method to be used by the new hedge fund, Crosby asks Garza to
forecast GDP growth. To do this, Garza obtains predictions for changes in several underlying
macroeconomic factors, including those listed Exhibit 1 with their predicted changes.
Exhibit 1: Predicted Changes in Economic Factors
Factor Predicted Change
Savings rate Decrease
Pollution controls Increase
Retirement age Increase
Garza then gathers the data in Exhibit 2 for the periods 1991-2000 and 2001-2010.
Exhibit 2: Historical Economic Data
Growth in
Output
Elasticity of
Capital
Total Factor
Labor Input
Capital (α)
Stock
Productivity
1991-2000 1.25% −0.50% 2.50% 0.6
2001-2010 2.35% 1.25% 0.42% 0.6
Using the data she gathered, Garza will calculate the implied price of the market index. She
notes that the major equity market index value is currently 1600 and the last dividend was $75.
She believes the required rate of return for the market is 8.0%.
Crosby then asks Garza to review the major relative valuation models and provide short
descriptions of each. Garza reviews the Fed model, the Yardeni model, and the 10-year moving
average price/earnings ratio model, P/10-year MA(E), and makes the following comments:
Comment
The Fed model compares the earnings yield for the S&P 500 index
1:
to the yield on U.S. Treasury securities. When the earnings yield
for the S&P 500 is greater than the yield on Treasury securities,
equities are said to be over-valued and should fall.
The Yardeni model is used to estimate earnings yield for a market
2:
index and is computed as the yield on A-rated corporate bonds less
the long-term growth rate forecast multiplied by a weighting
factor. Although the Yardeni model incorporates a risk premium
above that of Treasuries, the premium is not a true measure of
equity risk.
The 10-year moving average price/earnings ratio model is
3:
computed as the value of the S&P 500 index divided by the
average of the previous 10-years' reported earnings. One of the
major drawbacks of this model is that it does not consider the
effects of inflation.
After completing a review of the relative valuation models, Garza turns back to evaluating the
value of the market index. She now decides to employ the equity q ratio and gathers the
information in Exhibit 3:
Exhibit 3: Valuation Data ($Billions)
Market value (replacement cost) of assets 50
Book value of assets 35
Market value of liabilities 26
Market value of equity 20
...
In response to Crosby's question regarding the forecasting approach that would be best suited
for the hedge fund, Garza should suggest using a:
A) top-down approach.
B) bottom-up approach.
C) combination of top-down and bottom-up approaches.
Question #14 of 60
Which of the following is most likely correct regarding the predicted changes in the underlying
factors? All else equal, the predicted change in:
A) the savings rate will lead to an increase in GDP growth.
B) the retirement age will lead to an increase in GDP growth.
C) pollution controls will lead to an increase in GDP growth.
Question #15 of 60
The component of economic growth that contributed the most to real GDP growth during 1991-
2000 is:
A) labor input.
B) capital stock.
C) total factor productivity.
Question #16 of 60
If Garza assumes that the sustainable economic growth rate will be the same as the growth rate
realized over the period 2001-2010, the intrinsic value of the market index would be closest to:
A) 1578.
B) 1586.
C) 1637.
Question #17 of 60
Which of Garza's comments regarding relative equity market valuation models is correct?
A) Comment 1.
B) Comment 2.
C) Comment 3.
Question #18 of 60
Based on the equity q ratio, Garza would most likely conclude that the equity index is:
A) overvalued.
B) undervalued.
C) fairly valued
Question #19 of 60
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