13 - Relationship between return on asset classes

Question 1

Required return definition:

Answer 1

• Return that investors as a whole require on any asset class defined as:

Required return = Required risk-free real RoR + Expected inflation + Risk premium

o Terms on RHS of eqn represent mkt. averages as investors are considered as a class here

o Assume market defined risk-free rate in real terms not nominal (usually taken as real yield on index-linked bonds of appropriate term)

Question 2

Required return compensates investors for:

Answer 2

• Inflation so that the value of their assets does not decrease in real terms
• Compensation for additional risk incurred by undertaking investment

Question 3

What does the required return depend on?

Answer 3

• Investors’ preferences
  o If investor has real liabs, greater risk premium required on assets without inflation protection
• Characteristics of the assets

Question 4

Expected return definition:

Answer 4

Return that investor expects to make on an asset given:

• Price paid for asset
• Price for which investor expects to sell/redeem asset
• Expected income from asset while it is held

This can be broken down as:
Expected returns = Initial income yield + Expected capital growth

Question 5

Definition of fairly priced asset wrt required and expected returns
- What constitutes a cheap asset in this sense?

Answer 5

• Asset is said to be fairly priced when:
  Required return = Expected return
• Asset is considered cheap when:
  required return < expected return

Question 6

How would we further break down expected capital growth in the expected return formula and how do we obtain this expression?

Answer 6

Expected return = Initial income yield + [Income growth + Impact of change in income yield]

Price * Income yield = Income
Price = Income/Income yield
Any change in price (capital gain/loss) is either due to change in income or income yield

Question 7

How is equity growth related to GDP growth?

Answer 7

• GDP growth comes from use of land, labour and capital -: analogous to dividend growth in the company
• Greater GDP growth usually implies greater revenues, profits & dividends for companies & s/h
• Long-term dividend growth is expected to be closely in line w GDP growth assuming the capital share of GDP remains unchanged (wary of dilution effect)
• Hence equities are expected to provide real yield close to GDP growth + equity yield

Question 8

Dilution effect in equities and how it comes about:

Answer 8

• If div. yields are high new shares are issued to raise capital
• Equity ownership may become dilute => proportion of equity mkt held by s/h decreases
• Share of dividends received decreases (div yield drops)
• Dilution also depends on extent to which start-ups generate economic growth
  o If earnings of unquoted companies grow more than quoted companies, share of profits earned by quoted companies decline
  o Dividend growth will be less than GDP growth rate as a result

Question 9

How do the returns of fixed interest bonds fare wrt inflation & interest rate environments?

Answer 9

• If inflation is higher than expected, real return of fixed interest bonds will be lower than expected & poor compared to equities
• In periods when yields are rising, real returns on FI bonds will be worse than expected (this is particularly true if the bond is sold before maturity)

Question 10

Why may an investor NOT receive the GRY even after holding the FI bond to maturity?

Answer 10

• The borrower has defaulted on either the redemption or interest payments
• Impact of tax, dealing costs or exchange rate changes
• Coupons may have been reinvested at rates that differ from the quoted GRY