Chapter 13-Relationship between returns on asset classes Flashcards
- State a general formula for the return that investors as a whole require on an asset class.
Required return = required risk-free real rate of return + expected inflation + risk premium
- State two assumptions underlying the formula in the previous question.
The terms on the right hand side of the above equation represent market averages as investors are considered as a class here.
It is assumed that the market defines ‘risk-free’ in real rather than nominal terms.
- State the factors that influence the risk premium on an asset class.
The risk premium on a particular asset class will depend on the characteristics of the asset and investors’ preferences, which will be largely driven by their liabilities. A higher required return would be required from riskier asset classes. The risk premium in the equation above may cover any adverse feature of one investment relative to another for which investors require compensation.
- Give a formula that can be used to analyse expected returns on an asset class.
expected return = initial income yield + expected capital growth
- Under what circumstances will required and expected returns be equal? What market model expresses this idea?
If assets are fairly priced, required and expected returns will be equal. One market model which expresses this idea is the Capital Asset Pricing Model (CAPM) where expected returns are expressed as the return on a risk-free asset plus a risk premium dependent on the systematic risk of the asset.
- Explain why it is not possible to measure risk premiums by comparing historic actual and expected returns on an asset class.
In practice, investors in risky assets will not have received the returns they were expecting. Therefore, if assets were fairly valued at the time of purchase, risk premiums cannot be measured simply by comparing the returns on risky and risk-free assets.
- Give a formula that can be used to analyse historical returns on an asset class and explain how it can help identify the source of the performance.
The total return on an asset class can be expressed, to a first approximation, as:
Expected return = initial income yield + income growth + impact of change in yield
Here, income growth and change in yield represent capital growth. When analysing the expected return on asset classes over long periods of time it is also necessary to take account of the effect of the reinvestment of income at different initial yields and second-order terms arising from the fact that the expected return is expressed as a sum of percentage increases rather than as a product.
- Over the long term, what real returns might be expected on equities?
Over the long term equity dividend growth might be expected to be close to growth in GDP, assuming that the share of GDP taken by ‘capital’ remains constant. 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. Equities would therefore be expected to give a real return close to the growth in real GDP plus the equity yield.
From historical data this seems to be a reasonable model, but the short-term fluctuations are significant and the actual returns achieved by investors will depend on the exact timing of deals as well as their tax position.
- How can the return on both fixed-interest and index-linked bonds be analysed?
For fixed-interest stocks there is no income growth. The initial yield and the capital value change for a bond held to redemption combine to give a fixed nominal total return referred to as the GRY. The analysis of total returns compared with inflation is relatively straightforward:
* 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, and
* in periods when yields are rising, real returns from fixed-interest stocks are poor.
In both cases, the argument can be reversed to give the periods when fixed-interest stocks give good returns.
The real return on index-linked bonds is known at outset, if they are held to redemption. This real yield is often taken as the benchmark required real yield for the analysis of expected returns on equities. However, if index-linked bonds are sold before redemption then the actual real return will depend on the price for which the bonds are sold. This will be influenced by the normal supply and demand issues.
- Describe how the returns on cash might be expected to compare with inflation.
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.
