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Beltime Associates is a research firm that conducts market surveys and publishes reports on various worldwide market indices. In addition, the firm conducts research on

Beltime Associates is a research firm that conducts market surveys and publishes reports on various worldwide market indices. In addition, the firm conducts research on individual securities within specific countries on behalf of various portfolio management firms. The firms use Beltimes research reports to provide investment advice and services. Brent Holmes is a research analyst at Beltime Associates. Holmes is currently evaluating Lianors national equity index, a developing country, known as the Jesen equity index. Lianorians stock exchange opened for public trading 35 years ago, in January 1975, at which time the Jesen index was established. However, returns data for the index components are only available for the years 1990 and onwards. Holmes has estimated the returns for the pre-1990 period based on the shares of 15 companies which were in existence in January 1990 and components of the index. Using the 1990 returns data, Holmes has estimated shares returns for the 1975-1989 period based on the shares of the 15 corporations and has backfilled these returns. Jesen is a value-weighted index and, as of January 2010, it includes the shares of 45 corporations. The public opening of the Lianorian stock exchange fueled international cash inflows into the country. Aggressive international investors were enthusiastically investing in local corporations in large part due to the attractive expected returns promised by the corporations. However, the investors were met by heavy capital controls imposed by local authorities in an attempt to stem the steep rise in the Lianorian currency. This steep rise had partially been the result of the initial surge in foreign investment following the opening of the exchange. However, by 1989, capital controls had been completely removed. In addition to the Jesen equity index, Holmes is attempting to forecast the return, which investors can expect to earn on the S&P 500 index. The market forecast of long-term inflation, obtained from the U.S. Treasury, is 3.4% per year. From his discussion with analysts, labor productivity and supply growth rate are forecasted at 2.5% and 1.4%, respectively. The current P/E stands at 25.02 and is expected to grow at a rate of 1.45% per annum. The dividend yield on the index is 1.76% with a 15 bps reinvestment rate. The current 20-year U.S. government bond yield is 4.5%. Following his evaluation of the S&P 500, Holmes moves on to analyze the stock of Littleton Inc., a textile manufacturer based in Morocco. As an emerging market stock, Holmes believes that the determination of its expected return may be complicated by several factors, two of which are outlined below. Factor 1: As an emerging market corporation, the systematic risk of Littleton Inc.s stock relative to the Moroccan equity market index will require a unique adjustment which entails adjusting beta for its tendency to revert to a mean value of 1.0 over the long-term. Factor 2: In order to estimate expected returns, the Fama-French model will need to be extended to the Pastor Stambaugh model by including an illiquidity risk premium to account for the illiquid nature of emerging market securities. Home Creations is a U.S. textile manufacturer. Holmes believes Home Creations may be an attractive investment for U.S. investors. In order to convince his institutional clients, Holmes collects data on the textile manufacturers stock as well as local market data (Exhibit 1).

Question 1:

Which of the following statements characterizes the implications of the heavy capital inflows that followed the public opening of the Lianorian stock exchange and the subsequent imposition of capital controls?

a) Opening of the stock exchange and imposition of capital controls will bias the historical equity risk premium downward.

b) The stock exchange opening implies that the historical return series may be non-stationary while the imposition of capital controls implies that the historical return series may be stationary.

c) Both events indicate that the pre- and post-equity risk premiums are possibly different.

Question 2:

Based on the data provided in exhibit 1, which of the following conclusions pertaining to Home Creations is most likely correct?

a) The market price for the Home Creations stock is more than its book value.

b) The return required on an investment in Home Creations will benefit from the stocks above-average market capitalization.

c) Home Creations is a growth stock.

Question 3: please explain/ justify

Should Holmes include the returns estimated for the 1975-1989 period, in addition to the post-1990 index returns, in his historical risk premium estimate for the Jesen equity index, will his estimate most likely be biased upwards, downwards, or forecasted accurately?:

Question 4:

As outlined by Holmes, which of the factors (factor 1, 2, or both) inaccurately represent(s) the difficulties associated with formulating return expectations for emerging markets?

Question 5:

Using the Ibbotson and Chens model, please calculate the supply side estimate of the equity risk premium expected on the S&P 500.

Question 6:

Based on the Fama-French model, what is the required return on an investment in Home Creations stock?

0-Day U.S. Treasury Bill

3.40%

20-Year U.S. Treasury Bond Yield

4.50%

Market Beta

1.24

Size Beta

- 0.46

Value Beta

0.24

Market Risk Premium

6.40%

Size Premium

3.50%

Value Premium

1.80

0-Day U.S. Treasury Bill

3.40%

20-Year U.S. Treasury Bond Yield

4.50%

Market Beta

1.24

Size Beta

- 0.46

Value Beta

0.24

Market Risk Premium

6.40%

Size Premium

3.50%

Value Premium

1.80

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