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 approximated expected return on an asset

Answer 2

Approx. Expected Return = initial income yield + income growth + impact of change in yield

Change in yield (such as dividends, or rental yield) is important for investors who do not plan to hold the assets in perpetuity [look at slides].

Expected return =
initial yield
+ capital appreciation from income increases
+ capital appreciation from yield changes

Question 3

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

Answer 3

The assets are ‘fairly priced’

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

Formula for the expected return on equities

Answer 5

Equities (required i) = dividend yield (d) + expected nominal dividend growth(g) (= RFR + E(infl) + IRP)

Thus: i = d + g

Recall that PE ratio = 1 / earnings yield.

Question 6

Formula for the expected return on conventional bonds

Answer 6

Conventional bonds = GRY (nominal) (= RFR + E(infl) + IRP)

• For fixed-interest stocks there is no income growth.
• The initial yield and the capital value don’t change for a bond held to redemption

Question 7

Formula for the expected return on index linked bonds

Answer 7

Index linked bonds = GRY (real)

• The real return on index-linked bonds is known at outset, if they are held to redemption.
• The real yield is often taken as the benchmark required real yield for the analysis of expected returns on equities

Question 8

Formula for the expected return on property

Answer 8

Property = rental yield + expected nominal rental growth

Question 9

Formula for the expected return on cash

Answer 9

Cash = short term nominal interest yields

Question 10

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

Answer 10

• Over the long term equity dividend growth is expected to be close to growth in GDP, assuming that the proportion of GDP to “capital” remains constant.
• 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 extent to which economic growth is generated
  by start-up companies

Question 11

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

Answer 11

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 12

Discuss the factors affecting the expected return on cash

Answer 12

Expected to exceed inflation

Except where:

• inflation is rising rapidly
• inflation is under-estimated by investors.
• Short-term real interest rates very low by governments for significant periods.

Question 13

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

Answer 13

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

Question 14

Why would Government keep real interest rates high for a significant period? (3)

Answer 14

• Control aggregate demand/economic growth & inflation
• Encouraging workers/employees to demand wage increases in moderation
• Attract foreign investment

Question 15

Index-Linked Bonds Risk Premia

Answer 15

• Default Risk
• Liquidity Risk
• Volatility Risk

Question 16

Define the yield gap.

What are the uses and implications of the yield gap?

Answer 16

The yield gap or yield ratio is the ratio of the dividend yield of an equity and the yield of a long-term government bond.

Usually used to compare the relative values of conventional gov bonds and equities.

• If the yield gap is numerically small, then equity yield is lower than bond yield implying that the equity is overpriced.
• If the yield gap is numerically large, then equity yield is higher than bond yield implying that the equity is cheap