CFA Level III Essay Practice: Question #4 2011 Exam

Last year’s economics question for the essay portion of the level III CFA exam covered all new material. The material for this year’s test (2012) has not changed much, the requirement to evaluate the sensitivity of equity market value estimates to changes in assumptions has been dropped but you now need to be able to critique the use of the DDM and macroeconomic forecasts to estimate the intrinsic value of the market. The rest of the changes between last year’s and this year’s exams are minor wording changes.
Please download the essay portion of the exam, along with the guideline answers from the CFA Institute website to follow along with the post. We won’t be going over the actual answers here, but how to arrive at them and the important ideas you need to remember from the material.
A lot of the economics material revolves around a few concepts. Understand the Cobb-Douglas production function and how it’s used in equity market valuation. Be able to compare and contrast some of the economic characteristics between emerging and developed markets. Understand and be able to calculate both the Fed and Yardeni models.
Last year’s question #4 was worth a total of 23 points, or about 6.4% of the total exam points. While the topic area isn’t necessarily a make or break part of the exam, getting the concepts down is fairly easy and shouldn’t take much time.
Part A. The Cobb-Douglas is fairly simple and used to estimate a projected annual real GDP growth rate. It describes the relationship between the growth in labor, growth in capital, productivity and the general rate of growth in the economy.
GDP growth = (growth in Total Factor Productivity)+((Output Elasticity of Capital)(Growth in Capital)) +((1- Output Elasticity of Capital)(Growth in Labor Inputs))
Remember that the Output Elasticity of Capital and the Output Elasticity of Labor will equal 1 so if you are only given one of the data points then you must find the other. In contrast to the above formula, you might be given the Output Elasticity of Labor.
* Rather than spending too much time on how the mathematical formula is derived, understand how events and regulations affect the TFP and growth in capital or labor. These may include:

  • Major changes in political or regulatory structures
  • Liberalization in trade or investment
  • Increase or decrease in tax burden on business
  • Depletion or degradation of natural resources
  • Regulations that materially affect immigration or retirement

Part B. When asked how events or regulations affect GDP growth, don’t overthink it. The most direct effect is usually the correct answer, despite any secondary effects that might occur. Question #4b(1) is a good example of this. The guideline answer is that the increase in total fixed costs due to new regulations will lower the country’s GDP trend. I can guarantee though that some candidates missed the question by saying no change and citing the ‘long-term’ effects of improved productivity through updated machinery (as referred to in second half of answer provided).
Part C. I avoided the H-model almost entirely through my studying for the level III exam. It looked too complicated and I was hoping that chances were slim that I would see it on the exam. Fortunately, a week before the test I put it on a flash card and committed to learning it. As with most of the complex formulas, try to think through it intuitively and you should be able to pick enough up to make an educated guess on the exam.
Basically, the H-model is taking a basic DDM (initial dividend rate divided by discount rate minus long-term growth) but multiplies in a bonus because of supernormal growth (the difference in rates times half the years plus the long-term growth rate). The second part of the equation is a mathematical attempt at estimating a linear (straight line) decline in growth.
If you’re looking for more practice on the Cobb-Doublas or the H-model and its use in market valuation, you may want to check out the mock exams put out by FinQuiz. (Be ready though, its a tough one!)
Part D. The Fed model describes a relationship between the earnings yield on equities (forward operating earnings divided by price) and the yield on the 10-year treasury note. Though flawed, which will be addressed in the Yardeni model, the research behind the Fed model is really interesting right now given a earnings yield around 7% for equities and a 10-yr note at only 2%!
* What you need to remember about the model is what it says about market valuations, given the comparative yields, and that it is flawed because it ignores the equity risk premium, inflation and earnings growth.
The Yardeni model, actually named for the same guy as the Fed model, tries to fix some of the flaws in the prior model. It uses the Moody’s A-rated bond to account for risk in equities (though this is default risk, not equity risk) and the consensus five-year earnings growth forecast for the S&P500. As with the Fed model, be able to state what the model says about the current market valuation and compare it to other valuation models listed in the economics section.
Again, the economics material is not usually given a large weighting on the exam but most of the stuff is fairly conceptual or easily calculable. It is not a topic area in which you will need to focus, like individual asset management, but you should go over it a few times to pick up those easy points.
‘til next time, happy studyin’
Joseph Hogue, CFA

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