Chapter 14 - Relationship between returns on asset classes

Question 1

Give a general formula to determine the nominal required return for an asset

Answer 1

RR = required risk-free real rate + expected inflation + risk premium

• Terms on RHS are market-averages, as investors will have differing views
• Required risk-free real rate normally taken as real yield on an index-linked government bond
• Expected inflation normally taken as difference in real yield between fixed-interest government bonds and index-linked government bonds
• Risk premium depends on characteristics of asset and investor’s preferences/needs

Question 2

Give a general formula to determine expected return of an asset

Answer 2

ER = Initial income yield + expected capital growth

• Expected capital growth = Expected income growth + expected change in yield
• for equities, i = d + g (simple approximation)
• 1 + i = (1+d)(1+g) (actual)
  > Not the most important assumption and approximation usually appropriate
• Need to assume whether investor expects to sell the asset or hold to maturity (if possible)
• Income normally refers to expected income

Question 3

Why is it useful to compare required and expected returns of assets

Answer 3

If assets are fairly priced, RR and ER will be equal

If ER > RR, asset appears cheap to investor and is worth buying/holding

If ER < RR, asset appears to expensive to hold/buy and investor should sell/not buy

Question 4

Discuss how variables in expected return calculation can be determined for equities.

Answer 4

Over long term equity dividend growth (g) expected to be close to GDP growth
> Assume share of GDP attributed to capital (out of land, labour and capital) remains constant

ER = Expected GDP growth + equity yield

• This is real return
• Short-term fluctuations are significant

Actual return will depend on

• Timing of sale/purchase
• Tax position

Dilution effect*

• Read p. 6 & 7
• Need to adjust g

Question 5

Discuss how variables in ER calculation are determined for conventional bonds.

Answer 5

No income growth

ER = GRY

• This is real rate
• May need to make assumption regarding sale of bond before maturity

Actual return influenced by

• Inflation level
• Changes in yields over time

Question 6

Discuss how variables in ER calculation are determined for index-linked bonds.

Answer 6

ER = Fixed real yield + change in capital value
- Change in capital value only applicable on early sale of bond

Actual return will be influenced by

• Time lag on calculation of coupon and redemption payments based on past inflation
• Change in capital values if bond sold prior to maturity

Question 7

Discuss how variables in ER calculation are determined for cash.

Answer 7

ER = i >  expected inflation
- Not always the case
> High periods of inflation
> Underestimate inflation
> Government actions
> Kept very high/low for certain periods

• May also need to account for “resale” value as some MMI are transferrable

Question 8

Also go through slides for comparing prices of different asset classes

Answer 8

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