Chapter 24: Valuation of asset classes Flashcards
Required return for:
conventional government bond
risk-free real return
+ expected inflation
+ inflation risk premium
Required return for:
corporate bond
risk-free real return
+ expected inflation
+ corporate bond risk premium
Required return for:
Equity
risk-free real return
+ expected inflation
+ equity risk premium
Required return for:
Property
risk-free real return
+ expected inflation
+ property risk premium
Risk-free real return
The return on an index-linked government bond of an appropriate duration
Corporate bond risk premium
A margin to compensate for
- the risk of default,
- low marketability and liquidity and
- the uncertainty over future inflation.
Equity risk premium
A margin to compensate for:
- the risk of default,
- low marketability and liquidity and
- high volatility of share prices and dividends
Property risk premium
A margin to compensate for:
- the risk of default, void
- low marketability and liquidity
- indivisibility
- depreciation
- obsolescence
- volatility of property prices
Expected return for a conventional government bond
Gross redemption yield
Expected return for a corporate bond
Gross redemption yield
Expected return for an equity
Dividend yield + expected dividend growth
Expected return for a property
rental yield + expected rental growth
When does an asset ‘seem cheap’?
If required return < expected return
Simplifying assumptions when equating expected and required return to derive a fair value
- all investors want a real rate of return
- all investors have the same time horizon
- tax can be ignored
- reinvestment of income occurs at the expected return
Reverse yield gap equation
= gross redemption yield on conventional government bonds - equity dividend yield = Inflation risk premium - equity risk premium \+ expected dividend growth