Question 1

Frank Hoskins and Paul Lanning are economists for a large U .S . investment advisory firm. Platinum Advisors. Hoskins and Lanning use their independent research on U .S . stocks and international stocks to provide advice for the firm's network of advisors. As the senior economist at Platinum, Hoskins is a partner in the firm and is Lanning's supervisor. Lanning has worked for Platinum for the past four years. At a lunch meeting, the two economists discuss the usefulness of economic theory, economic data, and the resulting forecasts of the global economic and stock market activity.
Hoskins is investigating the growth prospects of the country of Maldavia. Maldavia is a formerly communist country with a population of 3 million located in Eastern Europe. The Maldavian government had been aggressive in instituting political reform and encouraging the growth of financial markets. However, due to a recent insider trading scandal and resulting stock market volatility, the Maldavian government is considering restrictions on further stock market growth and the establishment of a national securities regulator. Hoskins states that these developments are not encouraging for future economic growth.
Lanning is examining the country of Petra. Petra is a country of 25 million located in South America and rich with natural resources including oil. The recently elected president of Petra, Carlos Basile, has announced that he would like to diversify the country's economy away from natural resources while nationalizing the oil industry. Lanning states that these changes would not be beneficial for the future growth of the Petrian economy.
One of the many items they study when examining an economy or stock market is the economic information released by governments and private organizations. Hoskins and Lanning use this information to determine the effects on economic growth and the appropriate portfolio allocations to the bond and stock markets. Examining information for Maldavia, Hoskins has learned that the Maldavian private sector has embarked on an ambitious plan to increase labor productivity by purchasing more machinery for its factories. The private sector feels compelled to do this because Maldavia has historically relied too heavily on labor as the main input into production. Plotting the productivity curve for Maldavia, Hoskins states that labor productivity should increase because the productivity curve will shift upward and to the right.

Lanning is examining the historical record of economic growth in Petra. He has gathered the data in Exhibit 1 to determine potential economic growth.

Hoskins is also examining data for the country of Semeria. Semeria is an emerging country that has benefited from recent changes in the political environment as well as technological advances. Its economy is growing rapidly, and changes in the Semerian economy and society have resulted in more opportunities for women. The Semerian economy has experienced 17 consecutive quarters of positive growth in GDP, which is unprecedented in Semerian history. Interest rates have increased over time because businesses have been borrowing heavily to invest in new machinery and technologies. Most economists are forecasting further increases in interest rates in Semeria.
It has long been Platinum's policy that its economists use long-term economic growth trends to forecast future economic growth, stock returns, and dividends in a country. Lanning is examining the economy of Tiberia. Tiberia has a population of 11 million and is located in northern Africa. Its economy is diversified, and its main exports are agricultural products and heavy machinery. The country's economy has been growing at an annual rate of 6.2% for the past ten years, in part because of technological advances in the manufacture of heavy equipment. These advances involve the use of computer-operated welding machines that have made the manufacture of heavy equipment less expensive. Lanning is worried, however, that the 6.2% GDP growth rate may not be sustainable and is considering advising Platinum's portfolio managers to decrease their portfolio allocations in the country. Before doing so, he will consult with Hoskins.
Are the statements made by Hoskins and Lanning regarding the future growth of the Maldavian and Petrian economies likely to be correct or incorrect?

Options :

A : Both are correct.

B : Only Hoskins is correct.

C : Only Lanning is correct

Answer: A

Question 2

Emily De Jong, CFA, works for Charles & Williams Associates, a medium-sized investment firm operating in the northeastern United States. Emily is responsible for producing financial reports to use as tools to attract new clients. It is now early in 2009, and Emily is reviewing information for O'Connor Textiles and finalizing a report that will be used for an important presentation to a potential investor at the end of the week.
Following an acquisition of a major competitor in 1992, O'Connor went public in 1993 and paid its first dividend in 1999. Dividends are paid at the end of the year. After 2008, dividends are expected to grow for three years at 11%: $2.13 in 2009, $2.36 in 2010, and $2.63 in 2011. The average of the arithmetic and compound growth rates are given in Exhibit 1. Dividends are then expected to settle down to a long-term growth rate of 4%. O'Connor's current share price of $70 is expected to rise to $72.92 by the end of the year according to the consensus of analysts' forecasts.

O'Connor's annual dividend history is shown in Exhibit 1.

De Jong is also considering whether or not she should value O'Connor using a free cash flow model instead of the dividend discount model.

The output from the regression appears in Exhibit 2.
De Jong determines that employing the CAPM to estimate the required return on equity suffers from the following sources of error:
* Estimation of the model's inputs (e.g., the market risk premium). The company's dividend payment schedule.
* The accuracy of the beta estimate.
* Whether or not the model is the appropriate one to use.
De Jong observes that two reputable statistical analysis firms estimate betas for O'Connor stock at 0.85 and 1.10. She concludes that the differences between her beta estimate and the published estimates resulted from her use of standard errors in her regression to correct for serial correlation; the other firms did not make a similar adjustment.
De Jong considers using adjusted beta in her analysis. Typically, her company uses 1/3 for the value of .

She determines that her adjusted beta forecast will be closer to the mean reverting level using this value than it would be using a value of 1/3.
Is De Jong correct with respect to her conclusions regarding the causes of the differences between her beta estimate for O'Connor and the published beta estimates, and her strategy for adjusting her beta estimate to more quickly approach the mean reverting level of beta?

Options :

A : Yes on both counts.

B : Yes on one count, and no on the other.

C : No on both counts.

Answer: B

Question 3

A client of Colby Nash, CFA, wants to add an alternative asset class to his portfolio. However, the client is concerned that any investment in hedge funds may be far riskier and generate lower returns than is generally expected. Nash believes the client's attitude toward hedge funds was influenced by negative press coverage regarding fraud perpetrated by a few funds. Nash decided to conduct his own research on the risk/reward characteristics of hedge funds. Nash generated a report (shown in Exhibit 1) comparing several hedge fund strategies and a traditional investment benchmark; the S&P 500 index. Each hedge fund strategy is represented by an individual fund, which is used to measure risk and return over a ten year period. Nash also created a correlation matrix between hedge funds and the S&P 500 index, shown in Exhibit 2.

In addition to the statistics presented in the exhibits above, Nash created a hedge fund index to evaluate each fund's performance. Nash recognized the fact that several shortcomings exist in creating an adequate hedge fund index. To that end, Nash created an index in which all the hedge funds included in the index agreed to provide data that can be verified by Nash. Nash also set up strict rules for inclusion and removal of hedge funds into and out of the hedge fund index.
As a further improvement to his research, Nash created a positive risk-free rate benchmark to evaluate each hedge fund. However, his review of academic research indicated thar the positive risk-free rate benchmark is only appropriate for a limited number of hedge fund strategies. The current risk-free rate is 4%.
Nash conducted a personal interview with the portfolio manager of the Fixed Income Arbitrage hedge fund. The portfolio manager disclosed that he exploited pricing inefficiencies between fixed income securities while hedging exposure to interest rate risk. The portfolio manager utilizes a convergence trading strategy, which assumes that the price difference between two similar assets will narrow in the future. The portfolio manager is willing to invest in illiquid bonds if the opportunity presents itself.
in reviewing the correlation matrix (Exhibit 2), Nash concluded that the Fixed Income Arbitrage hedge fund would be an ideal addition to his client's current traditional investment portfolio. Nash's rationale was that a low correlation between the hedge fund and the S&P 500 index will assure that the fund's returns will be positive when the returns of the index are negative.
After reviewing Nash's research, the Director of Research at his firm inquired why he did not examine the value at risk (VAR) measure for the various hedge fund strategies. Nash stated that VAR is an ineffective statistical measure of risk when a hedge fund has high turnover or frequent changes in its strategy. In addition, Nash stated his belief that when the only input is historical data, VAR does not provide a reliable estimate of future risk.
Nash stated that correlation analysis indicated that the Fixed Income Arbitrage hedge fund should be added to his client's traditional investment portfolio and Nash outlines his rationale for not including VAR in his analysis of hedge funds. Which of his statements is correct?

Options :

A : Only the correlation statement is correct.

B : Only the VAR statement is correct.

C : Both statements are correct.

Answer: B

Question 4

Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.
The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.
Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, 'Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?'
Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:
* The risk-free rate of return is 2.7%.

* The expected risk premiums arc:

* The beta coefficient in the CAPM is estimated to be 0.63.
* The betas (factor sensitivities) for the three Fama-French factors are 1.00 for the market factor, -0.76 for the size factor, and -0.04 for the book-to-markct factor.
Trotter also asks Tang about adjusted betas. She says, 'We use a formula for the adjusted beta where the adjusted beta = (2/3) (regression beta) + (1/3) (1.0). How do the adjusted betas compare to the original regression betas?'
Trotter has one final question for Tang. Trotter says, 'We need to estimate the equity beta for VixPRO, which is a private company that is not publicly traded. We have identified a publicly traded company that has similar operating characteristics to VixPRO and we have estimated the beta for that company using regression analysis. We used the return on the public company as the dependent variable and the return on the market index as the independent variable. What steps do I need to take to find the beta for VixPRO equity? The companies have different debt/equity ratios. The debt of both companies is very low risk, and I believe I can ignore taxes.'
The best response to Trotter's question about survivorship bias is:

Options :

A : historical estimates.

B : Gordon model estimates.

C : survey estimates.

Answer: A

Question 5

Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:
Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).
Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. Oneof the advantages is comparability between the two methods since both calculate return relative to systematic risk.
Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.
The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:
1. One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.
2. The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.
3. Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.
4. Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.
Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.
Nielsen's findings on long/short equity funds and fixed income arbitrage strategies, respectively, are:

Options :

A : incorrect on both findings.

B : incorrect on long/short funds but correct on fixed income arbitrage funds.

C : correct on long/short funds but incorrect on fixed income arbitrage funds.

Answer: C

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