CH 14: Relationship between returns on asset classes

Question 1

Required return on an asset

4

Answer 1

• Required Return = req risk free real return + expected inflation + risk premium
• Investors req that investments don’t decrease in real terms
• Risk free real: index linke dgov bond
• Risk premium: Additonal return for taking risk

Question 2

Expected return on an asset

2

Answer 2

• Expected return = initial income yield + expected capital growth
• Investores expect to receive Price paid, exp selling price,exp income from asset

Question 3

What does it mean if the required return equals the expected return?

Answer 3

The assets are ‘fairly priced’

Question 4

What does it mean if the required return for an investor is less than the expected return

Answer 4

The asset appears cheap for that investor

Question 5

CAPM Exp Return

Answer 5

= rf rate + risk prem (systematic risk)

Question 6

Analysis of Exp returns

3

Answer 6

• Actual returns != expected for risky assets so even if fairly valued risk premiums cannot be compared using risk free assets
• Exp return = initial income yield + income growth +impact of change in yield
• Last 2 terms = expected capital growth (change in price)

Question 7

Expected return on equities

3

Answer 7

• Equities = dividend yield + expected nominal dividend growth
• Equities give real return inline with real GDP growth~ nom div growth
• Fairly priced exp return = LT IL Gov bond +Risk premium

Question 8

Over the long term, what is equity dividend growth expected to be close to?

Answer 8

It might be expected to be close to economic growth (growth in GDP), but this assumes that the share pf 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.

The dilution effect also depends on the extent to which economic growth is generated by start-up companies.

Question 9

Expected return on conventional bonds

2

Answer 9

• Conventional bonds = GRY (nominal)
• Fixed interest bonds have no income growth only initial yield and change in capital value = GRY

Question 10

Give two examples of when real returns on conventional bonds will be poor.

Answer 10

1. In periods when inflation turns out to be higher than expected.
2. In periods when yields are rising, real returns from fixed interest stocks are poor.

Question 11

Expected return on index linked bonds

3

Answer 11

• Index linked bonds = GRY (real)
• Real return known at outset if hold to redemption
• If sold before return depends on sale price

Question 12

Formula for the expected return on property

Answer 12

Property = rental yield + expected nominal rental growth

Question 13

Expected return on cash

2

Answer 13

• Exp Ret on Cash = short term nominal interest yields
• This should be > than inflation as expect real return

Question 14

Discuss the factors affecting the expected return on cash

Answer 14

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 interest rates can also be kept very high or very low by governments for significant periods.

Question 15

Over the long term, what are wages expected to grow in line with?

Answer 15

A reasonable assumption will be growth in line with GDP (i.e. economic growth)