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CFA Level II Chartered Financial Analyst Questions 1–150 (page: 52)

Arnaud Aims is assisting with the analysis of several firms in the retail department store industry. Because one of the industry members, Flavia Stores, has negative earnings for the current year, Aims wishes to normalize earnings to establish more meaningful P/E ratios. For the current year (2008) and six previous years, selected financial data are given below. All data are in euros.



Aims wishes to estimate normalized EPS for 2008 using two different methods, the method of historical average EPS and the method of average rate of return on equity. He will leave 2008 EPS and ROI out of his estimates. Based on his normalized EPS estimates, he will compute a trailing P/E for 2008. The stock price for Flavia Stores is €26.50.

Aims is also looking at price-to-book ratios as an alternative to price-to-earnings ratios. Three of the advantages of P/B ratios that Aims recalls are:

Advantage 1: Because book value is a cumulative balance sheet account encompassing several years, book value is more likely to be positive than EPS.
Advantage 2: For many companies, especially service companies, human capital is more important than physical capital as an operating asset.
Advantage 3: Book value represents the historical purchase cost of assets, as well as accumulated accounting depreciation expenses. Inflation and technological changes can drive a wedge between the book value and market value of assets.

Aims used a constant growth DDM to establish a justified P/E ratio based on forecasted fundamentals. One of his associates asked Aims if he could easily establish a justified price-to-sales (P/B) ratio and price-to-book (P/B) ratio from his justified P/E ratio. Aims replied, "I could do this fairly easily)

If I multiply the P/E ratio times the net profit margin, the ratio of net income to sales, the result will be the P/S ratio. If I multiply the P/E ratio times the return on equity, the ratio of net income to book value of equity, the result will be the P/B ratio."

Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to investigate these two investment criteria further.

Finally, Aims makes two comments to his associate about valuation ratios based on EBITDA and on dividends.

Comment 1: EBITDA is a pre-interest-expense figure, so I prefer a ratio of total equity value to EBITDA over a ratio of enterprise value to EBITDA.

Comment 2: Dividend yields are useful information because they are one component of total return. However, they can be an incomplete measure of return, as investors trade off future earnings growth to receive higher current dividends.

Are Aims's two comments about the dividend yield and EBITDA ratios correct?

Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been assigned to help Juanita Chevas, CFA, in the currency trading department. Together, Wilson and Chevas are working on the development of new trading software designed to detect profitable opportunities in the foreign exchange market. Obviously, they are interested in risk-free arbitrage opportunities.

However, they have also been instructed to investigate the possibility of longer-term currency exposures that are not necessarily risk-free. To test the logic of their new software, Wilson gathers the following market data:
• Spot JPY/USD exchange rate = 120.
• Spot EUR/USD exchange rate = 0.7224.
• U.S. risk-free interest rate = 7%.
• Eurozone risk-free rate = 9.08%.
• Japanese risk-free rate = 3.88%.
• Yield curves in all three currencies are flat.

In addition to in-house currency transactions, the new software program is also intended to provide insight into currency exposure and hedging needs for the bank's major customers. These customers typically include large multinational firms. Essentially, the bank wants to provide consulting services to its clients concerning which currency exposures offer the greatest possibility of appreciation. In this process, the bank will rely on deviations from international parity conditions as an indicator of long-term currency movements.

Wilson obtains the following data from the econometrics department:
• JPY/USD spot rate one year ago =116.
• EUR/USD spot rate one year ago = 0.7200.
• Anticipated and historical U.S. annual inflation = 3%.
• Anticipated and historical Japanese annual inflation = 0%.
• Anticipated and historical Eurozone annual inflation = 5%.

One of the bank's major customers has significant portions of its business in Japan, and the Eurozone and has long exposure to both currencies. The customer has traditionally hedged all currency risk. However, the customer's new risk manager has decided to leave some currency exposure unhedged in an attempt to profit from long-term currency exposure.

According to relative purchasing power parity, the expected JPY/EUR spot rate two years from now is closest to:

Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been assigned to help Juanita Chevas, CFA, in the currency trading department. Together, Wilson and Chevas are working on the development of new trading software designed to detect profitable opportunities in the foreign exchange market. Obviously, they are interested in risk-free arbitrage opportunities.

However, they have also been instructed to investigate the possibility of longer-term currency exposures that are not necessarily risk-free. To test the logic of their new software, Wilson gathers the following market data:

• Spot JPY/USD exchange rate = 120.
• Spot EUR/USD exchange rate = 0.7224.
• U.S. risk-free interest rate = 7%.
• Eurozone risk-free rate = 9.08%.
• Japanese risk-free rate = 3.88%.
• Yield curves in all three currencies are flat.

In addition to in-house currency transactions, the new software program is also intended to provide insight into currency exposure and hedging needs for the bank's major customers. These customers typically include large multinational firms. Essentially, the bank wants to provide consulting services to its clients concerning which currency exposures offer the greatest possibility of appreciation. In this process, the bank will rely on deviations from international parity conditions as an indicator of long-term currency movements.
Wilson obtains the following data from the econometrics department:

• JPY/USD spot rate one year ago =116.
• EUR/USD spot rate one year ago = 0.7200.
• Anticipated and historical U.S. annual inflation = 3%.
• Anticipated and historical Japanese annual inflation = 0%.
• Anticipated and historical Eurozone annual inflation = 5%.

One of the bank's major customers has significant portions of its business in Japan, and the Eurozone and has long exposure to both currencies. The customer has traditionally hedged all currency risk. However, the customer's new risk manager has decided to leave some currency exposure unhedged in an attempt to profit from long-term currency exposure.

Are the Japanese and Eurozone inflation forecasts provided by the econometrics department consistent with the inflation rates implied by the exact version of the international Fisher relation, given a U.S. inflation rate of3%?

Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been assigned to help Juanita Chevas, CFA, in the currency trading department. Together, Wilson and Chevas are working on the development of new trading software designed to detect profitable opportunities in the foreign exchange market. Obviously, they are interested in risk-free arbitrage opportunities.

However, they have also been instructed to investigate the possibility of longer-term currency exposures that are not necessarily risk-free. To test the logic of their new software, Wilson gathers the following market data:

• Spot JPY/USD exchange rate = 120.
• Spot EUR/USD exchange rate = 0.7224.
• U.S. risk-free interest rate = 7%.
• Eurozone risk-free rate = 9.08%.
• Japanese risk-free rate = 3.88%.
• Yield curves in all three currencies are flat.

In addition to in-house currency transactions, the new software program is also intended to provide insight into currency exposure and hedging needs for the bank's major customers. These customers typically include large multinational firms. Essentially, the bank wants to provide consulting services to its clients concerning which currency exposures offer the greatest possibility of appreciation. In this process, the bank will rely on deviations from international parity conditions as an indicator of long-term currency movements.

Wilson obtains the following data from the econometrics department:
• JPY/USD spot rate one year ago =116.
• EUR/USD spot rate one year ago = 0.7200.
• Anticipated and historical U.S. annual inflation = 3%.
• Anticipated and historical Japanese annual inflation = 0%.
• Anticipated and historical Eurozone annual inflation = 5%.

One of the bank's major customers has significant portions of its business in Japan, and the Eurozone and has long exposure to both currencies. The customer has traditionally hedged all currency risk. However, the customer's new risk manager has decided to leave some currency exposure unhedged in an attempt to profit from long-term currency exposure.

Wilson wants to approximate the forward discount/premium for the JPY against the USD 12 months from now. According to the approximate version of interest rate parity, the JPY would most likely trade at a:

Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been assigned to help Juanita Chevas, CFA, in the currency trading department. Together, Wilson and Chevas are working on the development of new trading software designed to detect profitable opportunities in the foreign exchange market. Obviously, they are interested in risk-free arbitrage opportunities.

However, they have also been instructed to investigate the possibility of longer-term currency exposures that are not necessarily risk-free. To test the logic of their new software, Wilson gathers the following market data:
• Spot JPY/USD exchange rate = 120.
• Spot EUR/USD exchange rate = 0.7224.
• U.S. risk-free interest rate = 7%.
• Eurozone risk-free rate = 9.08%.
• Japanese risk-free rate = 3.88%.
• Yield curves in all three currencies are flat.

In addition to in-house currency transactions, the new software program is also intended to provide insight into currency exposure and hedging needs for the bank's major customers. These customers typically include large multinational firms. Essentially, the bank wants to provide consulting services to its clients concerning which currency exposures offer the greatest possibility of appreciation. In this process, the bank will rely on deviations from international parity conditions as an indicator of long-term currency movements.
Wilson obtains the following data from the econometrics department:
• JPY/USD spot rate one year ago =116.
• EUR/USD spot rate one year ago = 0.7200.
• Anticipated and historical U.S. annual inflation = 3%.
• Anticipated and historical Japanese annual inflation = 0%.
• Anticipated and historical Eurozone annual inflation = 5%.

One of the bank's major customers has significant portions of its business in Japan, and the Eurozone and has long exposure to both currencies. The customer has traditionally hedged all currency risk. However, the customer's new risk manager has decided to leave some currency exposure unhedged in an attempt to profit from long-term currency exposure.

Suppose that Wilson expects the JPY/USD spot rate one year from now to fall by 2% from its current level. The foreign currency risk premium associated with the JPY is closest to: