Chapter 14: Relationship between returns on asset classes

Question 1

State the formula for required return on an asset

Answer 1

Required return = required risk-free rate of 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 + impact of change in yield

Question 3

Discuss required return vs expected return

Answer 3

If assets are fairly priced, required and expected returns will be equal.
CAPM expresses this idea 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

If for an investor, the expected return exceeds the required return, then the asset appears cheap.

Question 4

State the formula for expected return on equities

Answer 4

Expected return = dividend yield + expected nominal dividend growth

Question 5

What is dividend growth expected to be over the long term?

Answer 5

Over the long term, equity dividend growth might be expected to be close to growth in GDP assuming that the shares of GDP taken by ‘capital’ remains constant.

Equities therefore, would be expected to give a real return close to the growth in real GDP plus the equity yield.

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 6

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

Answer 6

• 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.
• In periods when yields are rising, real returns from fixed-interest stocks are poor.

Question 7

Discuss real returns in terms of index-linked bonds

Answer 7

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.

In other words, if equities are fairly priced in the market, then the expected return on equities should equal that on long-dated index-linked government bonds, plus a suitable risk premium

Question 8

List the factors that will be reflected in the risk premium

Answer 8

1. Differences in marketability
2. Uncertainty of the income and capital values provided by the equity
3. Possibility of default on the equity.

Question 9

Discuss the factors that influence the expected return on cash

Answer 9

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.

Question 10

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

Answer 10

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

The increase in economic growth comes from the various factors that contributed to its production - i.e. land, labour and capital

If the benefit of economic growth is shared equally between land, labour and capital, then wages should grow broadly in line with economic growth.