Chapter 14 - Relationship between returns on asset classes Flashcards

1
Q

Give a general formula to determine the nominal required return for an asset

A

RR = required risk-free real rate + expected inflation + risk premium

  • Terms on RHS are market-averages, as investors will have differing views
  • Required risk-free real rate normally taken as real yield on an index-linked government bond
  • Expected inflation normally taken as difference in real yield between fixed-interest government bonds and index-linked government bonds
  • Risk premium depends on characteristics of asset and investor’s preferences/needs
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2
Q

Give a general formula to determine expected return of an asset

A

ER = Initial income yield + expected capital growth

  • Expected capital growth = Expected income growth + expected change in yield
  • for equities, i = d + g (simple approximation)
  • 1 + i = (1+d)(1+g) (actual)
    > Not the most important assumption and approximation usually appropriate
  • Need to assume whether investor expects to sell the asset or hold to maturity (if possible)
  • Income normally refers to expected income
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3
Q

Why is it useful to compare required and expected returns of assets

A

If assets are fairly priced, RR and ER will be equal

If ER > RR, asset appears cheap to investor and is worth buying/holding

If ER < RR, asset appears to expensive to hold/buy and investor should sell/not buy

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4
Q

Discuss how variables in expected return calculation can be determined for equities.

A

Over long term equity dividend growth (g) expected to be close to GDP growth
> Assume share of GDP attributed to capital (out of land, labour and capital) remains constant

ER = Expected GDP growth + equity yield

  • This is real return
  • Short-term fluctuations are significant

Actual return will depend on

  • Timing of sale/purchase
  • Tax position

Dilution effect*

  • Read p. 6 & 7
  • Need to adjust g
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5
Q

Discuss how variables in ER calculation are determined for conventional bonds.

A

No income growth

ER = GRY

  • This is real rate
  • May need to make assumption regarding sale of bond before maturity

Actual return influenced by

  • Inflation level
  • Changes in yields over time
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6
Q

Discuss how variables in ER calculation are determined for index-linked bonds.

A

ER = Fixed real yield + change in capital value
- Change in capital value only applicable on early sale of bond

Actual return will be influenced by

  • Time lag on calculation of coupon and redemption payments based on past inflation
  • Change in capital values if bond sold prior to maturity
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7
Q

Discuss how variables in ER calculation are determined for cash.

A
ER = i >  expected inflation
- Not always the case
> High periods of inflation
> Underestimate inflation
> Government actions
> Kept very high/low for certain periods
  • May also need to account for “resale” value as some MMI are transferrable
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8
Q

Also go through slides for comparing prices of different asset classes

A

.

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