Chapter 14: Relationship Between Returns On Asset Classes

Question 1

State the formula for the required return on an asset

Answer 1

Required Return = risk free return + expected inflation + risk premium

Question 2

State the formula for the expected return on an asset

Answer 2

Expected return = initial income yield + expected capital growth

Approx = initial income yield + income growth + change in yield

Since

Price = income x annuity factor
= income x 1 / income yield

So the capital growth come from income growth and changes in the income yield

Question 3

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

Answer 3

The assets are priced at their fair value

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

Annuitisation factor

Answer 5

Price that investors will be willing to pay per unit of income

Question 6

Formula for the expected return on equities

Answer 6

Expected returns =
d + g (real) + (i = d+g)
expected inflation +
change in DY (“d”) (over holding period)

• Real GDP growth is a good starting for expected real “g”

• Expected inflation can be inferred from investment markets as the difference between nominal yields
on risk free-bonds nominal bonds less real yields on similar-term risk-free index-linked bonds (ignoring
the usually small inflation risk premium incorporated in nominal bond yields)

• “d” = historic DY (based on last 12m dividends) * (1+g)
…(as “d” must be prospective for the relationship to hold)

• Exit/sale price (if not held indefinitely): Assume an “exit multiple” on future sale i.e. P/d (or their
inverse income yields) to estimate exit price – depends on expected market conditions at time of
purchase and sale

Question 7

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

Answer 7

It might be expected to be close to economic growth (growth in GDP), but this assumes that the share of 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 8

Formula for the expected return on conventional bonds

Answer 8

Expected Return on Conventional bonds =
GRY (nominal) =

Initial Income yield (coupon rate) +
Change in yield (if sold prior to redemption)
- Higher than anticipated inflation → real
returns lower than expected
- Poor real returns when yields are rising

No income growth

Question 9

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

Answer 9

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 10

Formula for the expected return on index linked bonds

Answer 10

Expected Return on index linked bonds =
GRY (real)

Expected (real) return known at outset, provided:
• Reinvestment at same rate, hold to maturity, no time lag, etc..

Question 11

Formula for the expected return on cash

Answer 11

Expected Return on Cash =
short term nominal interest yields

• Expected to exceed inflation (i.e. Positive real rate of return)
• Exceptions occur when inflation is:
 Rapidly rising
 Under-estimated by investors
 Government actions on short-term real rates
 Kept very high / low for significant periods

Question 12

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

Answer 12

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