International Capital Markets

and Investment Practice

Part 8
Epilogue and exercises

Dr. Peter Oertmann

[email protected]

This lecture is largely congruent in content with the video

recording of the 2020 lecture available on lecturio.de
Part 8: Epilogue and exercises

Investing in challenging times

Problems and questions

© 2018-2022 Peter Oertmann 2

Diminishing returns – McKinsey‘s look into the future

1965-2014 1985-2014 next 20 years

Slow growth Growth recovery

Equities

USA 4.0% to 5.0% 5.5% to 6.5%

5.7% 7.9%
European 4.5% to 5.0% 5.0% to 6.0%

Fixed income

USA 2.5% 5.0% 0.0% to 1.0% 1.0% to 2.0%

Germany 4.2% 5.1%

France 3.7% 6.8% 0.0% to 1.0% 1.0% to 2.0%

United Kingdom 2.5% 4.9%

Source: Diminishing Returns, McKinsey Global Institute, May 2016

© 2018-2022 Peter Oertmann 3

Cornerstones of our understanding and investment implications

1. Today’s capital markets are neither

‘fully efficient’ nor ‘inefficient’ – a Portfolio diversification is demanding
modern understanding is that capital and requires a deep understanding of
markets are somewhat ‘adaptive’ or illiquid asset classes
inefficient to an efficient extent
2. Global capital markets have become
Opportunities for value creation
increasingly connected
encompass active investment strategies
3. Market parameters such as volatilities in risk premiums or economically
and correlations vary over time in motivated investment styles
accordance with business cycle
regimes and investor sentiment Risk management must incorporate
4. There exist multiple sources of global active market competences
investment risk
5. Risk premiums vary over time
corresponding to market participants’
willingness to take risk

© 2018-2022 Peter Oertmann 4

It‘s all about managing global business cycle risk

© 2018-2022 Peter Oertmann 5

10 statements on capital market risk and risk premiums

1. Only systematic risk is priced in capital markets.

2. The higher the systematic risk of an asset, the higher the asset’s expected return in the
long run – this is the fundamental concept of the Capital Asset Pricing Model (CAPM).
3. The scientific exploration of return drivers in capital markets starts with the assumption that
latent state variables exist that have a systematic impact on market participants´ valuation
of assets.
4. Rational valuation models claim that the systematic risk of an asset is captured by its
sensitivity to changes in the state of the global economy. Put simply, systematic risk is
equivalent to business cycle risk.
5. Multifactor asset pricing models in the spirit of the Arbitrage Pricing Theory (APT) describe
the state of the global economy by observable variables like interest rates, inflation rates,
output measures or commodity prices in addition to aggregate data on the valuation of
assets in capital markets.

© 2018-2022 Peter Oertmann 6

10 statements on capital market risk and risk premiums

6. Risk premiums vary over time corresponding to market participants’ assessments of the
state of the global economy and their respective appetite for risk.
7. Conditional asset pricing models capture at least a portion of the time-variation in risk
premiums by instruments describing market participants’ risk attitude as reflected in interest
rate spreads and aggregate fundamental valuation ratios.
8. Risk premiums can be harvested top-down by taking exposure to business cycle risk on the
asset allocation level or bottom-up by implementing specific investment styles like size,
value, profitability, investment, momentum or low risk in equity markets – the fundamental
sources of return are the same.
9. Any strategy to harvest risk premiums must include tactical competences to smooth the
performance over shorter investment horizons.
10. Since harvesting risk premiums means taking investment exposure to global business
cycle risk, it is consistent with the belief that asset prices in capital markets are
informationally efficient to a large extent.

© 2018-2022 Peter Oertmann 7

Part 8: Epilogue and exercises

Investing in challenging times

Problems and questions

© 2018-2022 Peter Oertmann 8

Problems and questions 1-10

1. What is the core statement of Fama’s Efficient Market Hypothesis (EMH)?

2. What are the implications of the EMH?
3. Explain the three forms of market efficiency.
4. What is the idea behind “efficiently inefficient markets” as formulated by Pedersen?
5. Briefly explain the concept of adaptive markets.
6. Name the three major fields for harvesting risk premiums.
7. Name three economically motivated investment styles.
8. From 1 May 2019 to 1 May 2020 the closing price of Apple stocks (NASDAQ: AAPL) increased from
210.52 USD to 289.07 USD. Calculate the simple return and the continuously compounded return.
9. The yearly volatility of the German stock market index DAX over the period from January 1993 to
February 2018 is 21.12% (see Case 1). Calculate the monthly volatility and the daily volatility of that
index.
10. The volatility of the S&P500 (US stock market) is 14.29% and the volatility of the Nikkei (Japanese stock
market) is 20.03% (see Case 1). The correlation between the two stock markets is 0.56. Calculate the
volatility of a portfolio with 40% invested in S&P500 and 60% invested in Nikkei.

© 2018-2022 Peter Oertmann 9

Problems and questions 11-20

11. What is roughly the long-term equity risk premium in accordance with the study of Dimson, Marsh and
Staunton?
12. What is the “typical” correlation between stocks and bonds measured over long periods of time
(approximate value)?
13. The correlation between stock and bond returns fluctuates over time: What is the fundamental
explanation of a negative correlation? What is the fundamental explanation of a positive correlation?
14. Explain the typical relationship between the volatilities on two stock markets and the correlation between
the markets.
15. Volatilities and correlations between markets vary over time: Briefly explain the stylized empirical facts
and the implications for investors.
16. Explain why returns on international investments are affected by exchange rate movements.
17. On 1 June 2018 the closing price of an Apple stock is 190.24 USD and 1 EUR costs 1.17 USD; on 1
June 2020 the closing price of an Apple stock is 321.85 USD and 1 EUR costs 1.11 USD. Calculate the
stock return over that 2-year period in USD and in EUR.
18. When does CPP hold?
19. Write down the formula for PPP in relative terms.
20. Today 0.90 EUR buy 1 USD. Economists forecast 1.5% inflation in the Eurozone and 3.0% inflation in
the US over the next year. Predict the EUR/USD exchange rate at the end of next year assuming that
PPP holds.

© 2018-2022 Peter Oertmann 10

Problems and questions 21-30

21. What is the implication of PPP for the returns on international assets for investors from different
countries?
22. Why is PPP only a poor explanation of short-term exchange rate movements?
23. Explain the concept of Economist’s Big Mac Index.
24. In the US the average price of a Big Mac in January 2018 is 5.28 USD. At the same time in China it is
20.40 Yuan which is equivalent to 3.17 USD at market exchange rates, and in Switzerland it is 6.50
Swiss francs which is equal to 6.76 USD. Comment on the relative valuation of the three currencies in
accordance with the Big Mac index.
25. The spot exchange rate between two currencies is 0.80. The domestic interest rate is 1.5% and the
foreign interest rate is 3%. Calculate the forward exchange rate.
26. Explain the core problem of international asset pricing.
27. In a closed economy (domestic setting) efficient portfolio diversification brings all investors on the same
efficient frontier which is essential for the derivation of the CAPM. Explain why in the international setting
there exists no unique efficient frontier.
28. On 20 April 2018 the price of an Apple stock is 172.80 USD and the price of one fresh white bread is
2.52 USD. One year before the stock price was 142.44 USD and the bread price was 2.40 USD.
Calculate the real return on Apple shares.
29. What additional assumptions have to be made in order to translate the base-line International CAPM in
real terms into a certain currency?
30. Comment on critical assumptions and the practicability of the base-line ICAPM.

© 2018-2022 Peter Oertmann 11

Problems and questions 31-40

31. Investors continuously face exchange risk due to unforeseen deviations from PPP. Explain the
implications for investors in different countries and for portfolio choice in the setting of IAPM’s.
32. What are the investment opportunities in the international asset pricing model of Solnik (1974)?
33. Describe the portfolio components in the IAPM of Solnik (1974).
34. What is the technical concept behind the world market portfolio hedged against exchange risk in the
IAPM of Solnik (1974)?
35. Explain the “separation idea” in the model of Solnik (1974).
36. Describe the portfolio choice in the IAPM of Adler and Dumas.
37. Explain the priced sources of risk in the Adler-Dumas model and the determinants of expected returns in
equilibrium.
38. Write down the asset pricing restriction of Adler and Dumas and explain its components.
39. Explain the idea of rational asset pricing.
40. Explain the approach of Chen, Roll and Ross (1986) to capture systematic forces that influence asset
returns.

© 2018-2022 Peter Oertmann 12

Problems and questions 41-50

41. Name three macroeconomic state variables applied in the study of Chen, Roll and Ross (1986).
42. Explain the idea of arbitrage pricing in a large capital market.
43. What might disturb arbitrage pricing of assets in the international environment?
44. Describe the components of the return generating model in the International APT.
45. What are the three crucial conditions for arbitrage pricing to hold in an international setting?
46. What is the assumption on exchange rate changes in the IAPT of Solnik?
47. Write down the pricing restriction of Solnik’s IAPT and explain its components.
48. Multifactor models are used to explore the drivers of asset return volatility. Explain the empirical
approach.
49. Explain the difference between volatility drivers and value drivers in capital markets.
50. Explain the two hypothesis of the Wald test procedure discussed in the lecture to identify factors with a
systematic influence on asset returns and potentially also the cross-section of expected returns.

© 2018-2022 Peter Oertmann 13

Problems and questions 51-53

51. A factor model including four uncorrelated global factors is applied to analyze the systematic risk of
selected European stock markets. The results of the analysis are documented in the following table (one
value is missing):

Factor 1 Factor 2 Factor 3 Factor 4

Factor volatility
10,0% 15,0% 18,0% 16,0%

Volatility Factor sensitivities (betas)

Germany 25,0% 0,45 -0,25 0,15 1,20
UK 16,0% 0,15 -0,15 0,12 missing
France 19,0% 0,40 -0,30 0,10 0,80

What portion of the variance of the German stock market is captured by factor 1?
52. With reference to the table in question 51: What portion of the variance of the French stock market is
explained by the model?
53. With reference to the table in question 51: 72.25% of the variance of the UK stock market is explained by
factor 4. Calculate the missing value.

© 2018-2022 Peter Oertmann 14

Problems and questions 54-60

54. With reference to the table in question 51: Exposure to the four global risk factors is compensated in
long-term returns. In a cross-sectional analysis the following risk premiums are estimated: 1.5% for
factor 1, -2.5% for factor 2, 1% for factor 3, and 4% for factor 4. Calculate the expected return for the
German and the French stock market assuming a risk-free interest rate of 1%.
55. How do the changes in the slope of the term structure of interest rates correspond to market participants’
business cycle expectations?
56. Explain the concept of intertemporal consumption smoothing in the context of the yield curve.
57. Name the three explanatory variables in the study of Fama and French (1989, Business Conditions and
Expected Returns on Stocks and Bonds).
58. How do expected returns on capital markets relate to economic conditions? Explain the general
message of the study of Fama and French (1989).
59. What is the economic explanation of a time-varying drift in the random walk model? (Part 5, Slide 20)
60. Write down the regression equation of an instrumental forecasting model and explain its components.

© 2018-2022 Peter Oertmann 15

Problems and questions 61-70

61. The dividend discount model is often the starting point for the search of instrumental variables in a
forecasting model. Explain why.
62. Briefly explain the idea of conditional asset pricing.
63. There is a debate on the reason for predictability in asset returns. Briefly summarize the findings of the
study of Ferson and Harvey (1991, The variation of economic risk premium) concerning this debate.
64. Write down the cross-sectional pricing restriction of a conditional beta pricing model including a linear
model capturing the time-variation of risk premiums.
65. Complete the following statement: “Markets are integrated if…”
66. What does market integration imply for the sources of risk and their pricing on global capital markets?
67. How can market integration be measured? Explain indicative as well as theoretically correct measures of
market integration.
68. Explain asset allocation and portfolio choice of conservative and aggressive investors in the framework
of Markowitz (1952). Draw a graph if you like.
69. Briefly explain the “asset allocation puzzle”.
70. Explain the difference between strategic and tactical asset allocation.

© 2018-2022 Peter Oertmann 16

Problems and questions 71-80

71. Describe the 4 quadrants of the framework of Brinson, Hood and Beebower to analyze the determinants
of portfolio performance.
72. The benchmark of a fund features 30% invested in equity markets and 70% invested in fixed income
assets (policy weights). The actual weights imposed by the fund management over the last 12 months
were 40% equity and 60% fixed income. The passive equity return was 4.5% and the passive fixed
income return was 1.5%, while the active returns achieved by the fund management were 5% in equity
and 1.0% in fixed income. Evaluate the active competences of the fund management.
73. Briefly describe the steps of a strategic asset allocation.
74. Explain the difference between a risk-oriented and a market-oriented portfolio overlay.
75. Explain the difference between an asset class risk premium, a style risk premium and a strategy risk
premium.
76. There are different philosophies to invest in stocks. What are the differences between High-conviction
strategies and passive investing in equity?
77. Write down the Gordon growth model and explain its components.
78. Which model could be used to calculate the discount factor in the Gordon model?
79. For a stock, a next dividend of EUR 4.50 and a long-term constant dividend growth of 5% is expected.
What is the intrinsic value of the stock if a discount factor of 8% is applied?
80. With reference to question 79: The market price of the share is EUR 130. How do you rate this current
market price?

© 2018-2022 Peter Oertmann 17

Problems and questions 81-90

81. With reference to question 79: How does the intrinsic value of the stock change if the expected dividend
growth weakens to 4%?
82. With reference to question 79: What dividend growth is implied in a stock price of EUR 180? We still
assume that the next dividend will be EUR 4.50, discounted at 8%.
83. What assumption about information efficiency is contained in the statement: “A stock is undervalued.”
84. Which indicators are used to select value stocks? Name 3 fundamental indicators.
85. What is the value trap?
86. Explain the investment philosophy of Warren Buffett.
87. Write down the empirical version of the CAPM.
88. What is meant by the ’joint hypotheses problem’ in the context of the CAPM?
89. How does the CAPM perform in empirical tests?
90. Name the two theoretical anchor points of multi-factor models.

© 2018-2022 Peter Oertmann 18

Problems and questions 91-99

91. How are equity returns explained in the Fama-French 3-factor model?
92. How are the factors constructed in a multi-factor model?
93. How is the Fama-French 3-factor model related to the ICAPM of Merton? Refer to the role of state
variables.
94. How does Carhart (1997) complement the Fama-French 3 factor model?
95. In the current academic debate there is talk of a ‘factor zoo’. What is this discussion about?
96. Factor-based equity investments have become very popular. What are the risk premiums of factor-based
strategies based on?
97. Comment on the stability of returns of factor strategies in equity markets.
98. What is the idea behind ETFs and why do ETF investments have many advantages?
99. Explain the two methods how ETFs can replicate an index.

© 2018-2022 Peter Oertmann 19

Part 8: Selected references

Oertmann, Peter (2018), How to understand and harvest risk premia in capital markets, Vontobel Asset
Management.
McKinsey Global Institute (2016), Diminishing returns: Why investors may need to lower their expectations

© 2018-2022 Peter Oertmann 20