Reference no: EM132459356

Problem: 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.

Question 1:

Which of the following statements characterizes the implications of the heavy capital inflows that followed the public opening of the Lianorian stock exchange and the subsequent imposition of capital controls?

a) Opening of the stock exchange and imposition of capital controls will bias the historical equity risk premium downward.

b) The stock exchange opening implies that the historical return series may be non-stationary while the imposition of capital controls implies that the historical return series may be stationary.

c) Both events indicate that the pre- and post-equity risk premiums are possibly different.