Chapter 14: Relationship Between Returns On Asset Classes Flashcards

1
Q

Required Rate of Return

A

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

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2
Q

State the formula for the expected return on an asset

A

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

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3
Q

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

A

The assets are priced at their fair value

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4
Q

What does it mean if the required return for an investor is less than the expected return

A

The asset appears cheap for that investor

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5
Q

Annuitisation factor

A

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

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6
Q

Formula for the expected return on equities

A

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
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7
Q

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

A

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.

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8
Q

Formula for the expected return on conventional bonds

A

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

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9
Q

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

A
  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
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10
Q

Formula for the expected return on index linked bonds

A

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..

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11
Q

Formula for the expected return on cash

A

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
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12
Q

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

A

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

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