Exeter Asset Management Case Scenario

Deeba Kumar, Standish’s supervisor, stops by to see how his work is progressing. She asks him to research at least five countries for the new fund, suggesting Chile, Singapore, Great Britain, the United States, and Denmark as potential candidates. She cautions him that he needs to be aware of interest rate linkages among these economies, and she mentions three points that he should consider:

1. Because the Chilean peso appears to be undervalued relative to the British pound and is likely to rise, Chilean bond yields may be lower than they should be relative to British bonds.

2. The peg linking Denmark’s currency to the euro is considered to be at risk and likely to break. Therefore, Danish bond yields are expected to drop if the Danish krone weakens relative to the euro.

3. After removing expected inflation, the real bond yield is likely to be similar in Singapore and Sweden.

Standish next reviews recent political news and discovers:

• The Czech Republic is holding elections next month. The KSCM party is projected to gain a majority, with a proposal to significantly reduce tax rates.

• The Swiss government is considering imposing a tax on all non-resident bank accounts.

• Sweden has reduced the use of oil to less than 25% of its energy supply, due to concerns about oil price instability.

Standish now begins to develop models to help him decide which countries to include in the new fund. He prefers to use the simplest forecasting method, as long as the approach will help him predict the path of the economy, and the key variables that can influence security returns. Standish asks Kumar if she can advise him as to which approach is most appropriate given his preferences.

Next, Standish begins to identify specific assets to include in the developed markets portfolio. He originally considers equally weighted positions in selected assets in Chile, Switzerland and the United States. Exhibit 1 provides his summary of whether inflation is likely to remain within the expected range in each country for his selected asset classes. Based on this summary, he ponders how he should adjust the portfolio weights to reflect these economic forecasts.

Exhibit 1

Inflation Relative to Expected Range

Country	Asset Class	Expected Inflation
Chile	Real Estate	Above expected range
Switzerland	Bonds	Above expected range
United States	Stocks	Within expected range

Standish now begins to develop models to help him decide which countries to include in the new fund. He prefers to use the simplest forecasting method, as long as the approach will help him predict the path of the economy, and the key variables that can influence security returns. Standish asks Kumar if she can advise him as to which approach is most appropriate given his preferences.

Question

The most appropriate economic modeling approach that Kumar should suggest is:

1. A.a checklist approach.

2. B.econometric modeling.

3. C.leading economic indicator-based analysis.

Solution

C is correct. Leading indicator-based analysis is the simplest forecasting approach because it requires following only a limited number of variables. Leading economic indicators may provide information about upcoming changes in economic activity, inflation, interest rates and security prices.

A is incorrect. Checklist assessments are time consuming because they require looking at the widest possible range of data and may require subjective judgment.

B is incorrect. Econometric models may be difficult to construct, estimate and interpret if they contain more than a few variables, yet more variables may be needed to make a model more realistic.

Capital Market Expectations, Part 1: Framework and Macro Considerations Learning Outcome

1. Compare major approaches to economic forecasting

Standish next reviews recent political news and discovers:

• The Czech Republic is holding elections next month. The KSCM party is projected to gain a majority, with a proposal to significantly reduce tax rates.

• The Swiss government is considering imposing a tax on all non-resident bank accounts.

• Sweden has reduced the use of oil to less than 25% of its energy supply, due to concerns about oil price instability.

From Standish’s review of political news, he can reasonably conclude that the country that is least likely to experience a macroeconomic shock is:

1. A.Sweden.

2. B.Switzerland.

3. C.Czech Republic.

Solution

A is correct. Sweden’s extreme reduction in oil usage makes it less likely than other countries to experience an oil shock, one of the two most common economic shocks.

B is incorrect. A major change in government policy, such as taxes as indicated for Switzerland, is likely to cause a shift in economic trends.

C is incorrect. A new government or a major change in government policy, as indicated for the Czech Republic, is likely to cause a shift in economic trends.

Capital Market Expectations, Part 1: Framework and Macro Considerations Learning Outcome

1. Explain how exogenous shocks may affect economic growth trends

Next, Standish begins to identify specific assets to include in the developed markets portfolio. He originally considers equally weighted positions in selected assets in Chile, Switzerland and the United States. Exhibit 1 provides his summary of whether inflation is likely to remain within the expected range in each country for his selected asset classes. Based on this summary, he ponders how he should adjust the portfolio weights to reflect these economic forecasts.

Exhibit 1

Inflation Relative to Expected Range

Country	Asset Class	Expected Inflation
Chile	Real Estate	Above expected range
Switzerland	Bonds	Above expected range
United States	Stocks	Within expected range

When considering the proposed weights for the developed markets portfolio, the most appropriate adjustment for Standish to make is to reduce the asset weighting in:

A.Chile.

B.Switzerland.

C.the United States.

Solution

B is correct. With above-average inflation, Chilean real estate is expected to outperform. Below-average inflation would likely cause US equities to outperform but have a neutral effect on Swiss bonds. Therefore, Standish should reduce the weight in Swiss bonds relative to the other two assets.

Capital Market Expectations, Part 1: Framework and Macro Considerations Learning Outcome

1. Explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns

By ChatGPT

1. Chile (Real Estate): Inflation is expected to be above the expected range. High inflation can negatively impact real estate investments, as it may lead to higher interest rates, which can decrease property values and increase the cost of borrowing for real estate investments. (May not be holistic here) 🛑

2. Switzerland (Bonds): Similarly, if inflation is above the expected range, it generally has a negative impact on bond investments. Higher inflation can lead to higher interest rates, which inversely affects bond prices (as bond prices typically decrease when interest rates rise). 🟢

3. United States (Stocks): Here, inflation is expected to be within the expected range. Generally, moderate inflation is not as detrimental to stock markets compared to real estate or bond markets, as many companies can pass on the increased costs to consumers or may even benefit from inflationary environments. 🟢

Deeba Kumar, Standish’s supervisor, stops by to see how his work is progressing. She asks him to research at least five countries for the new fund, suggesting Chile, Singapore, Great Britain, the United States, and Denmark as potential candidates. She cautions him that he needs to be aware of interest rate linkages among these economies, and she mentions three points that he should consider:

1. Because the Chilean peso appears to be undervalued relative to the British pound and is likely to rise, Chilean bond yields may be lower than they should be relative to British bonds.

2. The peg linking Denmark’s currency to the euro is considered to be at risk and likely to break. Therefore, Danish bond yields are expected to drop if the Danish krone weakens relative to the euro.

3. After removing expected inflation, the real bond yield is likely to be similar in Singapore and Sweden.

Of Kumar’s three points regarding interest rate linkages among countries proposed for the new fund, she is least likely correct with respect to bond yields in:

1. A.Singapore and Sweden.

2. B.Denmark.

3. C.Chile.

Solution

B is correct. Kumar’s second point regarding Danish bonds is incorrect. When two currencies are pegged or linked, the bond yields of the country with the weaker currency are likely to rise higher unless the market is confident that the government will maintain the peg. (hmm? isn't the peg expected to break)

C is incorrect. Kumar’s first point regarding Chilean bonds is a true statement. If a country’s exchange rate is severely undervalued and is expected to rise substantially against another country’s, then bond yields in the first country will be lower than they would otherwise be in relation to the other country. Since Chile’s exchange rate relative to Great Britain’s is undervalued, we would expect the Chilean bond yields to be lower than they should be as compared to the yields on the British bonds.

A is incorrect. Kumar’s third point with respect to Singapore and Sweden is a true statement. Although real yields can vary, they can and do tend to move together.

Capital Market Expectations, Part 1: Framework and Macro Considerations Learning Outcome

1. Identify and interpret macroeconomic, interest rate, and exchange rate linkages between economies

[ChatGPT]

1. Chilean Peso and British Pound: Kumar suggests that the Chilean peso, being undervalued relative to the British pound, might lead to Chilean bond yields being lower than they should be relative to British bonds. If the peso is indeed undervalued and expected to rise, this could . However, if the rise in the peso's value is not yet priced into the bond market, this could indicate that current yields may be artificially low.

2. Danish Krone and Euro Peg: The statement that the peg linking Denmark’s currency to the euro is at risk of breaking, and that this would likely lead to a drop in Danish bond yields if the Danish krone weakens relative to the euro, is somewhat counterintuitive. Typically, if a currency is expected to weaken and a peg is at risk, investors might demand higher yields for the increased risk, not lower yields. However, this could depend on the specific dynamics of the situation and market perceptions.

3. Real Bond Yields in Singapore and Sweden: Kumar’s point that, after adjusting for expected inflation, the real bond yield is likely to be similar in Singapore and Sweden could be plausible, assuming that both countries have similar economic conditions and inflation rates. This would imply that their bond markets are moving in tandem to some extent.

ChatGPT Reference: https://chat.openai.com/c/85077192-0ee0-42e8-8d73-5ca554eb8abd