Question 7 on CFA page in PF management section - appreciate if anyone could explain. All 3 should be part of discount rate as per my understanding? Is it because the topic on macro forecasting models not a particular product, say bond?
Thanks in advance!
Chan’s previous experience was working as a junior analyst for an equity fund. Morgan is impressed with Chan’s ability to model earnings but realizes he is still relatively inexperienced with macro forecasting models. Morgan mentions to Chan that the uncertainty of future cash flows is reflected by the discount rate, which is composed of three key components. He asks Chan if he knows what they are. Chan responds that the three distinct components can be thought of as
the additional return required from investing in a nominal default-free investment for investing in a real default-free investment;
the expected return on an inflation-linked bond issued by the government of a developed country; and
the increased premium for more actively traded securities relative to less actively traded securities
Q. Which of Chan’s comments regarding components of the discount rate is most likely correct?
3
2
1
Solution
B is correct. The expected return on an inflation-linked bond issued by the government of a developed country represents the return that an investor requires on a real default-free fixed-income security and is a key component of the discount rate.
A is incorrect because the required risk premium is an input in determining present value.
C is incorrect because the real risk-free rate is an input in determining present value.
Expected Inflation + YTM of real default free investment + risk premuin for cashflows of the asset = discount rate 1 and 3 are not components of the discount rate surely B is the correct answer
I’m a bit confused by this question too. In the CFAI Curriculum, the denominator of the Present Value formula is given as:(1+lt,s+θt,s+ρit,s) (Equation 1, reading 50)
However, the Discount Rate equation is given as 1+lt,s+θt,s+ρit,sfors=1 (Equation 2, Reading 50).
I don’t really understand the difference and why the answers A and C were incorrect.
Another bad question. What discount rate? The investment hurdle rate from CAPM? Or the risk free rate? Based on the whim of a poor question writer, what is most likely correct… What they are going after here is that CAPM uses the real risk free rate, which will theoretically be the real default free rate, often a sovereign bond that counters inflation-- hence, an inflation linked bond issued by a country. Think of a German government inflation linked Euro denominated bond as giving you the real risk free rate of return in the Eurozone. What’s dumb is this “the increased premium for more actively traded securities relative to less actively traded securities” could arguably be interpreted as the liquidity premium in some models if you allow the premium to be negative. One might be tempted to think they’re trying to trip you up with linguistic gimmicks.
I agree the solutions are worded in a weird way, but right off the bat, #3 is definitely not correct. You wouldn’t add a negative premium to the formula - you would add a liquidity premium for less actively traded securities, but not the other way around.
#1 is just plain confusing. That leaves #2 as the most clear answer.