Beltime Associates is a research firm that conducts marketsurveys and publishes reports on various worldwide market indices.In addition, the firm conducts research on individual securitieswithin specific countries on behalf of various portfolio managementfirms. The firms use Beltime’s research reports to provideinvestment advice and services. Brent Holmes is a research analystat Beltime Associates. Holmes is currently evaluating Lianor’snational equity index, a developing country, known as the Jesenequity index. Lianorian’s stock exchange opened for public trading35 years ago, in January 1975, at which time the Jesen index wasestablished. However, returns data for the index components areonly available for the years 1990 and onwards. Holmes has estimatedthe returns for the pre-1990 period based on the shares of 15companies which were in existence in January 1990 and components ofthe index. Using the 1990 returns data, Holmes has estimatedshares’ returns for the 1975-1989 period based on the shares of the15 corporations and has backfilled these returns. Jesen is avalue-weighted index and, as of January 2010, it includes theshares of 45 corporations. The public opening of the Lianorianstock exchange fueled international cash inflows into the country.Aggressive international investors were enthusiastically investingin local corporations in large part due to the attractive expectedreturns promised by the corporations. However, the investors weremet by heavy capital controls imposed by local authorities in anattempt to stem the steep rise in the Lianorian currency. Thissteep rise had partially been the result of the initial surge inforeign investment following the opening of the exchange. However,by 1989, capital controls had been completely removed. In additionto the Jesen equity index, Holmes is attempting to forecast thereturn, which investors can expect to earn on the S&P 500index. The market forecast of long-term inflation, obtained fromthe U.S. Treasury, is 3.4% per year. From his discussion withanalysts, labor productivity and supply growth rate are forecastedat 2.5% and 1.4%, respectively. The current P/E stands at 25.02 andis expected to grow at a rate of 1.45% per annum. The dividendyield on the index is 1.76% with a 15 bps reinvestment rate. Thecurrent 20-year U.S. government bond yield is 4.5%. Following hisevaluation of the S&P 500, Holmes moves on to analyze the stockof Littleton Inc., a textile manufacturer based in Morocco. As anemerging market stock, Holmes believes that the determination ofits expected return may be complicated by several factors, two ofwhich are outlined below. Factor 1: As an emerging marketcorporation, the systematic risk of Littleton Inc.’s stock relativeto the Moroccan equity market index will require a uniqueadjustment which entails adjusting beta for its tendency to revertto a mean value of 1.0 over the long-term. Factor 2: In order toestimate expected returns, the Fama-French model will need to beextended to the Pastor Stambaugh model by including an illiquidityrisk premium to account for the illiquid nature of emerging marketsecurities. Home Creations is a U.S. textile manufacturer. Holmesbelieves Home Creations may be an attractive investment for U.S.investors. In order to convince his institutional clients, Holmescollects data on the textile manufacturer’s stock as well as localmarket data (Exhibit 1). Question 1: Which of the followingstatements characterizes the implications of the heavy capitalinflows that followed the public opening of the Lianorian stockexchange and the subsequent imposition of capital controls? a)Opening of the stock exchange and imposition of capital controlswill bias the historical equity risk premium downward. b) The stockexchange opening implies that the historical return series may benon-stationary while the imposition of capital controls impliesthat the historical return series may be stationary. c) Both eventsindicate that the pre- and post-equity risk premiums are possiblydifferent. Question 2: Based on the data provided in exhibit 1,which of the following conclusions pertaining to Home Creations ismost likely correct? a) The market price for the Home Creationsstock is more than its book value. b) The return required on aninvestment in Home Creations will benefit from the stock’sabove-average market capitalization. c) Home Creations is a growthstock. Question 3: please explain/ justify Should Holmes includethe returns estimated for the 1975-1989 period, in addition to thepost-1990 index returns, in his historical risk premium estimatefor the Jesen equity index, will his estimate most likely be biasedupwards, downwards, or forecasted accurately?: Question 4: Asoutlined by Holmes, which of the factors (factor 1, 2, or both)inaccurately represent(s) the difficulties associated withformulating return expectations for emerging markets? Question 5:Using the Ibbotson and Chen’s model, please calculate the supplyside estimate of the equity risk premium expected on the S&P500. Question 6: Based on the Fama-French model, what is therequired return on an investment in Home Creations’ stock?

30-Day U.S. TreasuryBill	3.40%
20-Year U.S. TreasuryBond Yield	4.50%
Market Beta	1.24
Size Beta	- 0.46
Value Beta	0.24
Market RiskPremium	6.40%
Size Premium	3.50%
Value Premium	1.80%