14. Relationship between returns on asset classes

Question 1

What is the relationship between required and expected return

5

Answer 1

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

Expected return = initial income yield + expected capital growth

Approximation: initial income yield + income growth + impact of change in yield

If Required return = Expected return priced fairly
If Required return < Expected return cheap

Question 2

Expected Return on different asset classes. Equities, Conventional GB, index-linked bonds, property, cash

Answer 2

• Equities = Dividend yield + expected nominal dividend growth
• Property = rental yield + expected nominal rental growth
• Index-linked bond = GRY (real)
• Conventional bonds = GRY(nominal)
• Cash = short-term nominal interest rates

Question 3

When will the real returns on conventional bonds be poor?

Answer 3

• Inflation turns out to be greater than expected
• Period where yields are rising=> Market price of existing bonds decrease=> real return on these is lower

Question 4

Over the Long Term, What Is Equity Dividend Growth Expected to Be Close To?

Answer 4

• Economic growth → GDP

1. Assumes that the share of GDP represented by capital remains constant over time

• Dilution effect due to companies raising new capital
  1. Depends on how much start-up companies contribute to the economic growth

Question 5

What Factors Affect the Expected Return on Cash?

Answer 5

• Returns on cash are expected to be greater than inflation, except when:

1. Inflation is rising rapidly
2. Inflation is underestimated by investors
   * Short-term real interest rates kept high or low for a long period