Chapter 22: Relationship between returns on asset classes

Question 1

Return that investors, as a whole, require on any asset class

Answer 1

Required return
= required risk-free real rate of return
+ expected inflation
+ risk premium

Question 2

Expected return can be analysed as…

Answer 2

Expected return
= initial income yield
+ expected capital growth

Question 3

Capital growth occurs due to (2)

Answer 3

• income growth

- change in the initial income yield.

Question 4

Fairly-priced assets

Answer 4

Assets for which the required and expected returns are equal.

Question 5

Dividend growth on equities

Answer 5

• Over the long term equity dividend growth is expected to be close to growth in GDP, assuming that the proportion of GDP to “capital” remains constant.
• There is, however, a dilution effect due to:
  - the need for companies to raise new equity capital
  from time to time if dividend yields are high.
  - the extent to which economic growth is generated
  by start-up companies

Question 6

Growth / yield on conventional bonds

Answer 6

• For fixed-interest stocks there is no income growth.

- The initial yield and the capital value don’t change for a bond held to redemption

Question 7

Analysis of total returns compared with inflation

Answer 7

• in periods when inflation turns out to be higher than had been expected, real returns from fixed-interest stocks are lower than expected and are poor compared with equities
• in periods when yields are rising, real returns from fixed-interest stocks are poor.

Question 8

Real return on index-linked bonds

Answer 8

• The real return on index-linked bonds is known at outset, if they are held to redemption.
• The real yield is often taken as the benchmark required real yield.for the analysis of expected returns on equities

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Question 9

Returns on cash and relation to inflation

Answer 9

Expected to exceed inflation

Except where:

• inflation is rising rapidly
• inflation is under-estimated by investors.
• Short-term real interest rates very low by governments for significant periods.

Question 10

Index-Linked Bonds Risk Premia

Answer 10

• Default Risk
• Liquidity Risk
• Volatility Risk

Question 11

Why would Government keep real interest rates high for a significant period? (3)

Answer 11

• Control aggregate demand/economic growth & inflation
• Encouraging workers/employees to demand wage increases in moderation
• Attract foreign investment