Chapter 22: Relationship between returns on asset classes 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 share of GDP taken by “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.
Growth / yield on conventional bonds
For fixed-interest stocks there is no income growth.
The initial yield and the capital value change for a bond held to redemption yield.
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.
Returns on cash
Expected to exceed inflation
Except where:
- inflation is rising rapidly
- inflation is under-estimated by investors.
- Short-term real interest rates are kept very high or very low by governments for significant periods.
Set out the components of expected return
- Initial income yield
- Expected capital growth:
- — Income growth
- — Change in Yield