Page 9 - FINAL CFA II SLIDES JUNE 2019 DAY 7

Macroeconomic Multifactor Models: READING 27: RETURN CONCEPTS
They use factors associated with economic variables
that can be reasonably believed to affect cash flows MODULE 27.1: RETURN CONCEPTS
and/or appropriate discount rates.

The Burmeister, Roll, and Ross model incorporates the following five factors:

confidence risk = 2.0% Unexpected change in the difference between the return of risky corporate bonds and government bonds.

time horizon risk = 3.0% Unexpected change in the difference between the return of long-term government bonds and Treasury bills.
inflation risk = 4.0% Unexpected change in the inflation rate.

business cycle risk = 1.6%
Unexpected change in the level of real business activity.
market timing risk = 3.4%
The equity market return that is not explained by the other four factors.
As with the other models, to compute the required return, factor values are multiplied by a sensitivity coefficient (i.e., beta) for that stock; the products are summed and
added to the risk-free rate.

Build-Up Method
required return = RF + equity risk premium + size premium + specific-company premium
(size of premium would be scaled up or down based on the size of the company).

Suppose that we are also An example is the bond-yield plus risk premium method
given the following
sensitivities for stock j: EXAMPLE: Company LMN has bonds with 15 years to maturity. They have a coupon of 8.2% and a price
0.3, –0.2, 1.1, 0.3, 0.5, equal to 101.70. An analyst estimates that the additional risk assumed from holding the firm’s equity
respectively. Using the risk- justifies a risk premium of 3.8%. Given the coupon and maturity, the YTM is 8%. Calculate the cost of
free rate of 3.4%, calculate equity using the bond-yield plus risk premium approach.
the required return using a
multifactor approach. Answer: cost of equity = 8% + 3.8% = 11.8%
required return = Don’t loose sight what the components of each method convey: If asked in the
3.4% + (0.3 × 2%) + (–0.2 × 3%) + (1.1 × 4%) + (0.3 × 1.6%) exam evaluate style and/or the overall impact of a component on return,
+ (0.5 × 3.4%) = 9.98%
separate out each factor and its beta—paying careful attention to whether there
is a + or - sign attached to the component—and work through it logically.