Capital Market Expectations

CFA Level III Economics
#1

Hi All,

I was doing the EOC # 3 practice problem for Capital Market Expectations.

For part B, I do not understand why 1% was deducted from 1.20% ?

Help please.

Thanks,

#2

I think it relates to this statement - and footnote

“10-year MBS prepayment risk spread (over 10-year Treasuries)a” = 95 bps

“aThis spread implicitly includes a maturity premium in relation to the 1-year T-note as well as compensation for prepayment risk.”

so “Spread of 10-year over 1-year Treasury note” which is 1% needs to be removed for the 10 yr MBS case.

#3

It relates to whether the investor will invest if the combined risk premium of the three investments is 50bps or greater than 10 year Treasury premium, which is 1%(premium over the T-Bill).

So adding the three investment premiums:

T-Bill=0%

10 yr callable Bond= 1%+.8%+.9%=2.7%

MBS=.95%

So after doing the weighted RP (1.22%), you check whether the investor is getting 50bp premium over the 1%. 1.22-1.00=.22

#4

Another Capital Market question.

In question #4, part C…it asks to calculate the expected ERP. I thought you would need to find the expected bond yield instead of the current bond yield by taking the difference in inflation(3.5%-2.6%=.9) and adding it to the current bond yield, to get an expected bond yield of 4.7%(3.8%+.9%).

So expected ERP=expected Equity Return- expected bond yield. However, they use the current bond yield instead…anyone know why this is?

Thanks

#5

If it’s in real terms, then you use the current bond yield.

#6

Thanks Nova.

#7

I went back to this q and I still do not see clearly why ! % is deducted from 1.22?

#8

take a big magnifying glass see what is on the footnote, then read what I have written above …

#9

Still this question, part A, can you please help explain why they use long term inflation expectation instead of current inflation rate?

When they calculate expected return for 1 year T-Note, they use real return + long term inflation expectation instead of real return + current inflation rate

Thanks

#10

you never use the current inflation rate because it does not mean anything from a longer term perspective…

#11

Thank you.

#12

Alternatively, to make additional investment expected spread / premium of equally weighted investment should be at least 0.5% over 10yr Treasury bond and this could be solved as follows:

= 5.02 % (answer in A) minus (1.2% + 2.6% + 1%)

= 0.22%

#13

these EOCs are bullshit