SAMPLE WORK
QUESTION 1
August 2025 Question One A
Evaluate THREE approaches that a portfolio manager could use to undertake economic forecasting.
Answer
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Econometric Modeling: This uses mathematical and statistical models to establish relationships between economic variables (e.g., interest rates, GDP, employment). Multiple linear regression allows analysts to test the strength of these relationships and predict outcomes based on changing parameters
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Time Series Analysis: This approach relies on past data to forecast future events, assuming that historical patterns will continue. Examples include:
- Moving Averages: Used to smooth out data fluctuations to identify trends.
- Exponential Smoothing: Assigns higher weights to recent data to better reflect current trends.
- SARIMA (Seasonal ARIMA): Used to forecast data with regular seasonal patterns.
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Qualitative Approaches: These methods depend on subjective evaluations, expert opinions, and judgment-based information. They are particularly valuable when historical data is scarce or unavailable, such as during new market conditions or major structural shifts
- Machine Learning & Hybrid Models: Modern managers use tools like Facebook’s Prophet to handle complex datasets, missing data, and outliers. They also apply regime detection, utilizing machine learning to identify stable or volatile economic periods to adjust asset allocation.
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QUESTION 2
April 2025 Question Five A
Explain SIX components of a systematic framework for capital market forecasts.
Answer
- Define Asset Classes: Establish which investment categories to include based on investor goals, strategy, and market availability.
- Gather and Analyze Data: Collect comprehensive historical and current data, including economic metrics, market performance (returns/volatility), and relevant socio-political trends.
- Project Macroeconomic Drivers: Transform data into specific forecasts for key economic factors such as inflation, GDP growth, interest rates, and exchange rates that influence asset performance.
- Estimate Asset Returns and Risks: Use the economic forecasts and historical data to calculate projected returns, risks (volatility), and correlations for each asset class.
- Run Scenarios and Stress Tests: Validate the forecasts by simulating various economic conditions (e.g., recessions or high inflation) to evaluate potential outcomes and model robustness.
- Document and Communicate: Maintain detailed records of all data, assumptions, and methodologies to ensure transparency and effectively communicate the rationale behind the forecasts to stakeholders.
QUESTION 3
December 2024 Question One A
Development of capital market forecasts is fundamental for portfolio Explain FOUR challenges to developing capital markets forecasts.
Answer
- Psychological Biases (Cognitive Errors): Analysts often fall into traps such as status quo bias (extrapolating the past), anchoring (over-relying on initial figures), confirmation bias (seeking data that supports existing views), and overconfidence in their predictive ability.
- Model and Input Uncertainty: Choosing the right model (e.g., discounted cash flow vs. risk premium) and selecting inputs (e.g., 2-year vs. 10-year risk-free rate) is complex. Minor changes in inputs can lead to vastly different, and often wrong, forecasts.
- Limitations of Economic Data: Financial data can lack timeliness, contain measurement errors, or be revised constantly. Furthermore, survivorship bias (ignoring failed companies) can skew results, and appraisal data often paints a smoother, less volatile picture than reality.
- Non-stationarity and Structural Changes: Historical data (e.g., correlations between asset classes) often fails to predict future performance because market environments, regulations, or economic structures change over time (e.g., shifting interest rate regimes).
- Ex-Post Risk Misinterpretation: Interpreting past volatility (\(ex-post\)) as a reliable indicator of future risk (\(ex-ante\)) is flawed. Historical data might reflect a, low-probability catastrophe that did not occur (making risk look low) or a one-time shock that did (making risk look high)
QUESTION 4
August 2024 Question One A
Alois Mwenda, a financial analyst with Fadhili Capital LLC is conducting a capital markets expectation forecast for the upcoming year for their international portfolio.
Mwenda gathers the following details:
- Maldina county has a GDP of Sh.60 billion and has an economy dominated by the mining industry. It is an emerging market and Maldina’s current account deficit has been growing over
- Ocenia county has a GDP of 1.2 trillion and has an economy that sells a variety of items.
- Mwenda predicts a global economic slowdown for the upcoming
- Mwenda believes that Gross Domestic Product (GDP) is the best forecast using a system of equations that can capture the fact that GDP is a function of many variables both current and lagged values.
Required:
- Explain to Alois Mwenda why a growing current account deficit is a sign of increasing
- Explain which county between Maldina and Ocenia is at a greater risk given the expected global economic slowdown.
- Recommend to Alois Mwenda which economic forecasting method is most appropriate to use
Answer
i) Explanation to Alois Mwenda why a growing current account deficit signals increasing risk:
A widening current account deficit means Maldina County is importing more goods, services, and capital than it exports. This imbalance must be financed, typically through foreign borrowing. A persistent, growing deficit raises risk because it increases foreign indebtedness—Maldina must borrow from international markets, raising its foreign debt burden and making it more vulnerable to changes in global interest rates and investor sentiment.
ii) Which county (Maldina or Ocenia) faces greater risk given an expected global economic slowdown:
Maldina County is at greater risk than Ocenia County because it is an emerging market with an economy dominated by the mining industry.
iii) Recommendation to Alois Mwenda on the most appropriate economic forecasting method:
Econometric modeling is recommended. This method uses an estimated system of equations to forecast future economic variables, with the forecaster providing values for exogenous variables. Econometric models are highly useful for simulating the effects of changes in key variables. Their key advantage is that they enforce a degree of consistency and challenge the modeler to reconsider prior beliefs based on the model’s conclusions.
QUESTION 5
April 2024 Question Four A
Describe the following approaches used in setting capital market forecasts:
(i) Surveys.
(ii) Panel method.
(iii) Judgement.
Answer
QUESTION 6
December 2023 Question One A
In relation to forming capital market expectations, explain THREE approaches to economic forecasting.
Answer
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Econometric Modeling: This technique applies statistical methods to represent the relationships between important economic variables. An econometric model may be a single equation or a large system comprising hundreds of equations, designed to explain economic interconnections and project future values. These models are grounded in economic theory and historical data. For instance, a model might use interest rates, inflation, and unemployment figures to predict GDP growth.
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Economic Indicators: This approach involves examining various economic statistics that offer insights into the present condition and likely future path of the economy. These indicators are typically categorized as leading, coincident, or lagging.
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Leading indicators: Change before the broader economy and provide early warnings of future economic trends (e.g., stock market performance, consumer confidence index, building permits).
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Coincident indicators: Move in step with the business cycle and reflect the current state of economic activity (e.g., GDP, industrial production).
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Lagging indicators: Shift after the economy has already started following a new trend and are used to confirm the direction and magnitude of economic changes (e.g., unemployment rate, average unemployment duration).
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Checklist Approach: This is a more subjective and adaptable forecasting method. It involves a forecaster considering a broad range of factors both numerical and qualitative that they believe are relevant to the economic outlook. The forecaster relies on their own judgment and experience, along with data and analysis from multiple sources, to reach a conclusion. There is no standardized model; instead, it is a list of checkpoints that may include anything from econometric model outputs to geopolitical events and sentiment surveys.
QUESTION 7
August 2023 Question One A
Describe how each of the FIVE phases of business cycle affect the short-term and long-term capital market expectations.
Answer
Recovery: This stage begins right after a recession, when early signs of economic improvement start to appear.
Short-term outlook: Investor confidence begins to improve. Cyclical industries—such as consumer discretionary, industrials, and technology—tend to do well as company earnings rebound from low levels. Central banks usually keep interest rates low to support growth, which is generally favorable for stocks.
Long-term outlook: The longer-term perspective turns cautiously positive. Investors expect sustained economic expansion and rising profits. Funds gradually move from safer, defensive assets into growth-oriented investments, reflecting stronger potential for long-term gains.
Expansion: This phase is marked by steady economic growth, increasing employment, and higher consumer spending.
Short-term outlook: Corporate earnings are expected to remain strong, supporting rising asset prices. Toward the later part of this phase, worries about inflation and potential interest rate hikes may emerge, increasing market volatility.
Long-term outlook: While optimism remains, investors become more selective. Asset valuations may appear stretched, prompting concerns about overheating or excessive market enthusiasm. Attention shifts from aggressive growth toward higher-quality and value investments.
Peak: The peak represents the highest level of economic activity before a slowdown begins. Growth starts to ease, even though indicators remain near their highs.
Short-term outlook: Market sentiment becomes uncertain, and volatility rises. Earnings growth is expected to slow, and asset prices may level off or decline. Defensive sectors like utilities and consumer staples often gain favor as investors look for stability.
Long-term outlook: The outlook grows cautious or even negative. The likelihood of a recession increases, leading investors to reduce risk by reallocating funds from cyclical stocks to safer, more liquid assets such as government bonds or cash. Preserving capital becomes the priority.
Contraction (Recession): This stage involves declining economic activity, including shrinking GDP, rising unemployment, and lower corporate earnings.
Short-term outlook: Conditions are generally unfavorable. Asset prices often fall significantly, and investors expect weak earnings across many sectors. However, toward the end of the recession, some investors begin targeting undervalued assets in anticipation of recovery.
Long-term outlook: As the downturn progresses, the longer-term perspective improves. This phase often presents some of the best opportunities for future gains, as asset prices are low and markets begin to anticipate recovery. Attention shifts to the eventual turnaround and the next growth phase.
Trough: The trough is the lowest point in the business cycle, just before recovery begins. Economic indicators are at their weakest, and sentiment is highly pessimistic.
Short-term outlook: The near-term view remains negative, though conditions are not expected to worsen much further. Volatility can persist, and occasional short-lived rallies may occur, but caution dominates investor behavior.
Long-term outlook: This phase can offer the most attractive entry point for long-term investors. With valuations at their lowest, the potential for strong future returns is high. Expectations shift toward a new cycle of growth, with improving corporate earnings and economic expansion over time.
QUESTION 8
April 2023 Question One A
Identify TWO characteristics of each of the following phases of a business cycle on short-term and long-term capital market returns:
(i) Initial recovery.
(ii) Early upswing.
(iii) Slowdown.
(iv) Recession.
Answer
(i) Initial recovery:
• Short-term returns: Returns usually start improving as investor sentiment shifts from negative to positive. Cyclical stocks, which suffered most during the downturn, tend to rebound strongly.
• Long-term returns: The outlook becomes more attractive. Investors expect a sustained growth phase ahead, making this a favorable time to start building long-term positions.
(ii) Early upswing:
• Short-term returns: Performance is typically strong, supported by rising corporate earnings and high investor confidence, resulting in widespread gains in equity markets.
• Long-term returns: While expectations remain positive, some caution may arise. Increasing valuations can lead to concerns about the economy overheating, which might eventually trigger a slowdown.
(iii) Slowdown:
• Short-term returns: Returns tend to fluctuate more and may stagnate or decline. Investors grow wary of slowing economic growth and possible monetary tightening, with defensive sectors often outperforming growth-oriented ones.
• Long-term returns: The outlook becomes more guarded or even negative. With recession risks rising, investors shift toward safer assets and focus on preserving capital.
(iv) Recession:
• Short-term returns: Returns are generally negative across most assets. Prices fall, and investor sentiment weakens, while defensive sectors and government bonds often perform relatively better than equities.
• Long-term returns: Interestingly, the long-term perspective starts to improve during this phase. With valuations at their lowest, markets begin to anticipate recovery, creating strong opportunities for long-term investors.
QUESTION 9
December 2022 Question One B
Capital market expectations are the essential inputs to deciding on a strategic asset
In relation to the above statement, identify the SEVEN steps involved in the process of capital markets expectations setting.
Answer
- Define the asset universe: Start by identifying the range of asset classes to be analyzed, such as domestic equities, global fixed income, real estate, or private equity. This selection should align with the investor’s policy statement and available investment opportunities.
- Analyze relevant factors: Collect and evaluate data that may affect asset performance. This includes economic, social, political, and regulatory influences, along with historical trends and current market valuations.
- Project key financial variables: Use the insights from research to estimate major macroeconomic indicators like GDP growth, inflation, interest rates, exchange rates, and corporate earnings—these form the foundation of market expectations.
- Estimate asset class performance metrics: Translate the macro forecasts into expected returns, risk levels (volatility), and correlations for each asset class. This step represents the core of the forecasting exercise.
- Record forecasts and assumptions: Clearly document the projections, including the assumptions and methods used. This ensures transparency and allows for future review and updates as conditions change.
- Determine optimal asset allocation: Apply the forecasts of returns, risks, and correlations within a portfolio optimization framework to identify the asset mix that best suits the investor’s objectives and risk tolerance.
- Review and revise regularly: Continuously compare forecasts with actual outcomes and adjust them as needed. This ongoing process ensures expectations remain relevant in response to new data and evolving market conditions.
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