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P2.T8.702. Macroeconomic risk factors including growth, inflation and volatility (Andrew Ang)

Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Describe the process of value investing, and explain reasons why a value premium may exist [BT note: this objective is somewhat out of sequence; the next practice question will review the value premium ]. Explain how different macroeconomic risk factors, including economic growth, inflation, and volatility affect risk premiums and asset returns.


702.1. Andrew Ang introduces factors and divides them primary into two types: macro, fundamental-based factors versus investment-style factors. He writes, "Factors drive risk premiums. One set of factors describes fundamental, economywide variables like growth, inflation, volatility, productivity, and demographic risk. Another set consists of tradeable investment styles like the market portfolio, value-growth investing, and momentum investing."

Ang also claims that the three most important macro factors are growth, inflation, and volatility. His evaluation of these macro factors is based on a long-term historical sample (specifically, 1952:Q1 to 2011:Q4). It is important to qualify the sample window because we cannot be sure that past is prologue; e.g., interest rates experienced two long-term secular trends during this window.

In regard to his historical analysis, each of the following statements is true EXCEPT which is false?

a. Government and investment-grade bonds performed BETTER during economic recessions than during expansions
b. Both large and small (cap) stocks perform significantly BETTER during economic expansions than during recessions
c. During periods of high inflation, all five asset classes perform significantly BETTER than during periods of low inflation
d. All five assets classes are much MORE VOLATILE during recessions (or periods of low GDP growth) than during expansions

702.2. Andrew Ang says that volatility is one of the three most important macro factors. Each of the following statements about volatility, as a macroeconomic factor, is true EXCEPT which is false?

a. There is a negative correlation between stock returns and the VIX index
b. Volatility has a negative "price of risk" in aggregate markets including equities, fixed income, currency, and commodity markets
c. Due to volatility's negative "price of risk," an increase in volatility implies higher subsequent stock returns because there is a natural upper limit on volatility somewhere around 100%
d. The "leverage effect" refers an increase in stock volatility (riskier equities) due to a general increase in firm's financial leverage (i.e., assets divided by equity) caused by a drop in stock returns

702.3. In addition to the three major macro factors, Ang reviews several other macro factors including productivity risk, demographic risk, and political risk. According to Ang, each of these statements is true EXCEPT which is NOT necessarily true?

a. As the population ages, retirees purchase more financial assets and this demand puts upward pressure on asset prices
b. Older people have higher risk aversion such that as the average age in the population increases, the equity risk premium increases which implies a drop in equity prices
c. Before the global financial crisis, in general political risk was a meaningful macro risk factor only in emerging markets; but after to the crisis, political risk has become important also in developed countries.
d. In "real business cycle models," inflation is somewhat neutral because production economies are modeled to include firms that are subject to shocks that affect their output; this includes productivity shocks which work at longer-term business cycle frequencies such that asset returns reflect long-run productivity risk

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