CISI IoI Economic Indicators and Portfolio Theory — Questions and Answers
Question 1: What does 'GDP' (Gross Domestic Product) measure?
- The total value of a country's exports minus its imports
- The total monetary value of all goods and services produced within a country during a specified period (Correct answer)
- The total savings held by households in a country
- The total debt owed by a government
Correct answer: The total monetary value of all goods and services produced within a country during a specified period
GDP measures the monetary value of all final goods and services produced within a country's borders during a given period (usually quarterly or annually). It is the primary measure of a country's economic output and growth.
Question 2: What is 'inflation' and how is it measured in the UK?
- Inflation is economic growth; it is measured by GDP
- Inflation is the general rise in prices over time; in the UK it is primarily measured by the Consumer Prices Index (CPI) and Retail Prices Index (RPI) (Correct answer)
- Inflation is the rate at which wages increase; it is measured by the Average Earnings Index
- Inflation is measured by the FTSE 100 index performance
Correct answer: Inflation is the general rise in prices over time; in the UK it is primarily measured by the Consumer Prices Index (CPI) and Retail Prices Index (RPI)
Inflation refers to the general increase in prices over time, reducing purchasing power. The UK's main inflation measures are CPI (used by the Bank of England for the 2% inflation target) and RPI (used for gilt indexation and some contracts).
Question 3: What is a 'recession' in economic terms?
- A fall in the stock market of more than 20%
- Two consecutive quarters of negative GDP growth (Correct answer)
- A period of high inflation combined with low growth
- A rise in unemployment above 10%
Correct answer: Two consecutive quarters of negative GDP growth
A recession is defined as two or more consecutive quarters of negative economic growth (falling GDP). It typically involves rising unemployment, falling consumer spending, and reduced business investment.
Question 4: How does a rise in interest rates typically affect the economy?
- It stimulates spending by making borrowing cheaper
- It reduces consumer spending and business investment by making borrowing more expensive, thereby slowing economic growth and reducing inflation (Correct answer)
- It increases corporate profits by reducing companies' borrowing costs
- It has no effect on economic activity
Correct answer: It reduces consumer spending and business investment by making borrowing more expensive, thereby slowing economic growth and reducing inflation
Higher interest rates increase the cost of borrowing for households (mortgages, loans) and businesses, reducing spending and investment. This lowers aggregate demand, slowing the economy and reducing inflationary pressure — the Bank of England's intended effect when fighting high inflation.
Question 5: What does the 'yield curve' show?
- The historical performance of a bond fund over time
- The relationship between bond yields and their time to maturity — typically showing how yields change as the maturity lengthens (Correct answer)
- The return generated by the FTSE 100 over different time periods
- The relationship between a company's share price and its dividend yield
Correct answer: The relationship between bond yields and their time to maturity — typically showing how yields change as the maturity lengthens
The yield curve plots the yields (interest rates) of bonds of equal credit quality (e.g., gilts) against their maturities. A normal upward-sloping curve reflects higher yields for longer maturities. An inverted yield curve can signal an expected economic slowdown.
Question 6: What is 'modern portfolio theory' (MPT) and who developed it?
- A theory developed by Warren Buffett suggesting investors should focus on individual stock selection
- A theory developed by Harry Markowitz showing how combining assets with different correlations can construct portfolios that optimise return for a given level of risk (Correct answer)
- A theory developed by the Bank of England for managing national debt
- A theory developed by the FCA to govern how investment managers should construct client portfolios
Correct answer: A theory developed by Harry Markowitz showing how combining assets with different correlations can construct portfolios that optimise return for a given level of risk
Harry Markowitz's MPT (1952) demonstrates that by combining assets with imperfect correlations, investors can construct an 'efficient frontier' of portfolios offering the maximum expected return for each level of risk. Diversification is central to MPT.
CISI IoI Economic Indicators and Portfolio Theory
What does 'GDP' (Gross Domestic Product) measure?