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 Beltime's research reports to provide investment advice and services.

Brent Holmes is a research analyst at Beltime Associates. Holmes is currently evaluating Lianor's national equity index, a developing country, known as the Jesen equity index. Lianorian's 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 manufacturer's stock as well as local market data (Exhibit 1).

Exhibit 1
U.S. Market and Home Creations Stock Price Data

30-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%

Question 1:

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 stock's above-average market capitalization.

c) Home Creations is a growth stock.

Question

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 Beltime's research reports to provide investment advice and services.

Brent Holmes is a research analyst at Beltime Associates. Holmes is currently evaluating Lianor's national equity index, a developing country, known as the Jesen equity index. Lianorian's 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 manufacturer's stock as well as local market data (Exhibit 1).

Exhibit 1
U.S. Market and Home Creations Stock Price Data

30-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%

Question 1:

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 stock's above-average market capitalization.

c) Home Creations is a growth stock.

Accepted Answer

The required return here is a function of three factors: Market, size and value. Several statements…