Ch14: Relationship between returns on asset classes

Question 1

Required return

Answer 1

• The return that investors, as a whole, require on any asset class can be written as:
• Required return = required risk-free real rate of return + expected inflation + risk premium
• Value of investments should not decrease in real terms
• Should earn additional compensation over and above this for giving up the use of the cash that they invest over the period of investment.

Question 2

Risk premium in required return

Answer 2

Reflects compensation required for the risk that investors incur by undertaking the investment

Question 3

Expected return breakdown into components

Answer 3

• Expected return = initial income yield + expected capital growth
• Expected capital growth = Income growth + Change in yield
• In other words ECG = Changes in income + change in price per unit of income investors are willing to pay

Question 4

Equities: Expected return

Answer 4

• = d + g(real) + expected inflation + change in yield
• Real GDP growth good starting point for expected real ‘g’
• Need to adjust for:
  * Expected trend of share of GDP between capital, labour and land
  * Share of GDP taken by listed and non-listed sectors

Question 5

Conventional bonds: Expected return

Answer 5

• = GRY = Initial income yield (coupon rate) + NO income growth + Change in yield (if sold prior to redemption)
• If change in yield is higher than expected -> Real returns poor if sold prior to redemption

Question 6

Cash: Expected return

Answer 6

• Expected to exceed inflation
• Exceptions occur when:
  * Inflation is rapidly rising
  * Under-estimated by investors
  * Government may keep short-term real interest rates very high or low for significant periods

Question 7

Yield gap

Answer 7

• Equity gross dividend yield - GRY on benchmark bond = d - GRY
• ERP - IRP - ‘g’

Question 8

Expected return vs Required return

Answer 8

• Government bonds
  * GRY = RRR + E[infl] + IRP
• Corporate bonds
  * GRY = RRR + E[infl] + BRP
• Equities
  * d + g(d) = RRR + E[infl] + ERP
• Property
  * r + g(r) = RRR + E[infl] + PRP

Question 9

Risk premiums for asset classes

Answer 9

• BRP = Inflation + Default + Marketability risks
• ERP = Default + Volatility + Marketability + Inflation?
• PRP = Marketability + Default + Inflation