Chapter 14 - Relationship between returns on asset classes Flashcards
Give a general formula to determine the nominal required return for an asset
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
Give a general formula to determine expected return of an asset
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
Why is it useful to compare required and expected returns of assets
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
Discuss how variables in expected return calculation can be determined for equities.
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
Discuss how variables in ER calculation are determined for conventional bonds.
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
Discuss how variables in ER calculation are determined for index-linked bonds.
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
Discuss how variables in ER calculation are determined for cash.
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
Also go through slides for comparing prices of different asset classes
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