C13 Relationship between returns

Question 1

State the general formula for the return than an investors as a whole require on an asset class.

Answer 1

The return than an investors, as a whole, require on any asset class can be written as:

Required nomination return =
Required risk-free rate of return + Expected Inflation + risk premium

Question 2

State the formula for expected returns

Answer 2

Expected return = Initial income yield + Expected
capital growth

Question 3

Formula for historic return on an asset class

Answer 3

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

Question 4

Over long term, what returns might be expected from equities or

Equity dividend growth assumption

Answer 4

• Close to economic growth (growth in GDP) but this assumes that the share of GDP represented by capital remains constant over time
• 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. Dilution effect also depends on the extent to which economic growth is generated by start up companies
• Short term fluctuations are significant
• Return achieved by investors will depend on the timing of the deal and their tax position

Question 5

Assumption for equating required and expected returns

Answer 5

Key:
Assets are fairly priced (market is efficient) [CAPM]
Other:
All investors want a real return
All investors have the same time horizon for investment decisions
Tax differences between investors can be ignored
Reinvestment can occur at a rate equal to the expected total return on the asset

Question 6

How can returns on fixed-interest be analysed? OR

Situations where real return on conventional bonds will be poor

Answer 6

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. (Note that higher than expected inflation leads to a higher GRY on a conventional bond. Since price and yield have an inverse relationship on a conventional bond, this causes the price of the bond to fall and hence the return, as defined in the question, to fall)
In periods when yields are rising, real returns from fixed-interest stocks are poor. (Note that if yields, i.e. GRY, are rising then bond prices are falling. Hence the return, as defined in the question, falls)

Question 7

How can returns on index-linked bonds be analysed?

Answer 7

• Real return on index-linked bonds in known at the outset, if they are held to redemption
• The real yield is often taken as the benchmark required real yield for the analysis of expected rate of return from equities
• However, if index-linked bonds are sold before redemption, than the actual real-return will depend on the price for which the bonds are sold.
• This will be influenced by the supply and demand issues.

Question 8

Describe how the return on cash might be expected to be compared with inflation

Answer 8

• Returns on cash might be expected to exceed inflation except in periods where inflation is rising rapidly and is under-estimated by investors.
• Short-term real interest rates can also be kept very high or very low by governments for significant periods