13. Relationships between asset classes

Question 1

Required rate of return

Answer 1

RR = RFRR + EI + RP

• Terms on RHS are market averages
• Assumption: Market defines “risk-free” in real terms

Question 2

Expected return

Answer 2

What investors expect to achieve given:

• Purchase price
• Expected sale price/redemption amount
• Expected income

Question 3

ER formula

Answer 3

ER = Initial income yield + expected capital growth

ER = Initial income yield + income yield growth + impact of change in income yield

Question 4

Equities

Answer 4

• Long term: g expected grow close to GDP growth assuming that share of GDP taken by “capital” is constant.
• Short term: volatility and actual returns depend on timing of deals + tax

ER = d + g = d + RDG + EI

In efficient market:
d + RDG + EI = RFRR + EI + ERP
ERP = d + RDG -RFRR

Question 5

Conventional bonds

Answer 5

0-coupon: no income growth

GRY:
- Fixed nominal total return for a bond held to redemption

Returns compared to inflation:

• If inflation > EI, real returns < real returns from equity
• When yields are rising, real returns are poor

Question 6

Index-linked bonds

Answer 6

Held to redemption:
Real return known at outset

Sold before redemption:
Actual returns depend on price which is influenced by S+D factors

Question 7

Why earnings grow in line with GDP over time

Answer 7

• Labour factor from 3 factors of production

- Assume increase in production is shared equally

Question 8

(Reverse) Yield gap

Answer 8

YG = d- GRY

RYG = GRY - d
RYG = IRP -ERP + g

Question 9

Efficient market

Answer 9

RR = ER since A is fairly priced

Question 10

Cash

Answer 10

Might be expected to exceed inflation unless inflation > expected