Chapter 14: Relationships between return Flashcards
Return that investors, as a whole, require on any asset class
Required return
= required risk-free real rate of return
+ expected inflation
+ risk premium
Expected return can be analysed as…
Expected return
= initial income yield
+ expected capital growth
Capital growth occurs due to (2)
- income growth
- change in the initial income yield.
Fairly-priced assets
Assets for which the required and expected returns are equal.
Dividend growth on equities
- 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
Growth / yield on conventional bonds
- 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
Analysis of total returns compared with inflation
- 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.
Real return on index-linked bonds
- 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
Returns on cash and relation to inflation
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.
Index-Linked Bonds Risk Premia
- Default Risk
- Liquidity Risk
- Volatility Risk
Why would Government keep real interest rates high for a significant period? (3)
Control aggregate demand/economic growth & inflation
- Encouraging workers/employees to demand wage increases in moderation
- Attract foreign investment