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Capital Market Expectations, Part 1

5 minutes 5 Questions

Capital Market Expectations (CME) form the foundation of strategic asset allocation, guiding investment decisions by forecasting the future performance of various asset classes. In the context of CFA Level 3 and Economics, CME involves analyzing historical data, economic indicators, and market tren…

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CFA Level 3 - Capital Market Expectations, Part 1 Example Questions

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Question 1

As the head of the Capital Markets Expectations team at a global investment firm, you are responsible for developing long-term return forecasts for various asset classes. Your team has gathered the following data for the Japanese market: the current dividend yield on the Nikkei 225 is 1.5%, the expected earnings growth rate for Japanese large-cap stocks over the next 10 years is 3% per annum, and the current price-to-earnings (P/E) ratio of the Nikkei 225 is 18. Your team also expects the P/E ratio to expand by 10% over the forecast period due to improving investor sentiment and structural reforms in the Japanese economy. Based on this information, what is the most appropriate long-term capital market expectation for the total return on Japanese large-cap equities over the next 10 years?

Correct Answer: The most appropriate long-term capital market expectation for the total return on Japanese large-cap equities over the next 10 years is approximately 6.2%. This can be calculated as follows: Dividend yield (1.5%) + Earnings growth rate (3%) + Impact of P/E ratio expansion (1.8% per year, derived from the 10% expected expansion over the 10-year period, which equates to an annualized growth rate of 1.8%) = 6.3% expected total return.

The most appropriate long-term capital market expectation for the total return on Japanese large-cap equities over the next 10 years is approximately 6.2%. This can be calculated as follows:

Dividend Yield (1.5%) + Earnings Growth Rate (3%) + Impact of P/E Ratio Expansion (1.8%) = 6.3% Expected Total Return

The impact of the P/E ratio expansion is derived from the 10% expected expansion over the 10-year period, which equates to an annualized growth rate of 1.8% (calculated as (1 + 0.10)^(1/10) - 1).

The other answers are incorrect because they either miscalculate the impact of the P/E ratio expansion or they fail to include it in the total return calculation. The P/E ratio expansion is expected to contribute to the total return and should be included in the calculation.

Question 2

You are an investment analyst at a large pension fund, tasked with developing capital market expectations for the next 10 years. The fund's Investment Committee has provided you with the following information: the current yield on 10-year government bonds in your country is 2%, the expected inflation rate over the next decade is 1.5%, and the historical equity risk premium for your domestic market has been 4%. Your team also believes that the equity risk premium will expand by 75 basis points over the next 10 years due to increased geopolitical risks and demographic challenges. The current dividend yield on the domestic equity market is 3%, and earnings growth is expected to be 5% per year over the forecast period. Assuming a constant payout ratio and no change in valuation multiples, what is the most appropriate long-term capital market expectation for the total return on domestic equities over the next 10 years?

Correct Answer: 11.25%. The expected total return on domestic equities can be calculated as the sum of the current dividend yield (3%), expected earnings growth (5%), and the expected change in the equity risk premium (0.75%), which equals 8.75%. Adding the expected inflation rate of 1.5% and the current bond yield of 2% results in a total expected return of 11.25%.

The most appropriate long-term capital market expectation for the total return on domestic equities over the next 10 years is 11.25%. To calculate the expected total return, we sum up the following components: 1. Current dividend yield: 3% 2. Expected earnings growth: 5% 3. Expected change in the equity risk premium: 0.75% Adding these components gives us an expected equity return of 8.75%. To this, we add: 4. Expected inflation rate: 1.5% 5. Current bond yield: 2% The sum of all these components results in a total expected return of 11.25% for domestic equities over the next 10 years. The other answers are incorrect because they either: - Fail to properly account for the expected change in the equity risk premium - Incorrectly subtract the inflation rate from the nominal return instead of adding it - Add the historical equity risk premium to the calculation, which is not relevant given the expected change in the premium

Question 3

As the head of the Capital Markets Expectations team at a global investment firm, you are tasked with developing long-term return forecasts for the Mexican equity market. Your team has gathered the following data: the current dividend yield on the S&P/BMV IPC index is 2.5%, the expected earnings growth rate for Mexican large-cap stocks over the next 10 years is 5% per annum, and the current price-to-earnings (P/E) ratio of the S&P/BMV IPC is 20. Your team anticipates the P/E ratio to contract by 10% over the forecast period due to concerns about political uncertainty and economic challenges. Additionally, your team expects the dividend payout ratio to increase from 30% to 35% over the next decade as Mexican companies focus on enhancing shareholder returns. Based on this information, what is the most appropriate long-term capital market expectation for the total return on Mexican large-cap equities over the next 10 years?

Correct Answer: The most appropriate long-term capital market expectation for the total return on Mexican large-cap equities over the next 10 years is 6.5%. This can be calculated as follows: Dividend yield (2.5%) + Earnings growth rate (5%) - P/E contraction impact (-2%) + Dividend payout ratio increase impact (0.5%) = 6.5%.

The most appropriate long-term capital market expectation for the total return on Mexican large-cap equities over the next 10 years is 6.5%. This can be calculated as follows: 1. Start with the current dividend yield of 2.5%. 2. Add the expected earnings growth rate of 5% per annum over the next 10 years. 3. Subtract the impact of the anticipated 10% P/E ratio contraction. A 10% contraction on a P/E of 20 is equivalent to a 2% reduction in returns (10% ÷ 20 = 0.5; 0.5 × 5% earnings growth = 2% reduction). 4. Add the impact of the expected increase in dividend payout ratio from 30% to 35%. This 5 percentage point increase, applied to the 5% earnings growth, results in an additional 0.5% return (5% × 10% = 0.5%). Therefore, the total return expectation is: 2.5% + 5% - 2% + 0.5% = 6.5%.

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