Chapter 24: Valuation of asset classes

Question 1

Required return for:

conventional government bond

Answer 1

risk-free real return
+ expected inflation
+ inflation risk premium

Question 2

Required return for:

corporate bond

Answer 2

risk-free real return
+ expected inflation
+ corporate bond risk premium

Question 3

Required return for:

Equity

Answer 3

risk-free real return
+ expected inflation
+ equity risk premium

Question 4

Required return for:

Property

Answer 4

risk-free real return
+ expected inflation
+ property risk premium

Question 5

Risk-free real return

Answer 5

The return on an index-linked government bond of an appropriate duration

Question 6

Corporate bond risk premium

Answer 6

A margin to compensate for

• the risk of default,
• low marketability and liquidity and
• the uncertainty over future inflation.

Question 7

Equity risk premium

Answer 7

A margin to compensate for:

• the risk of default,
• low marketability and liquidity and
• high volatility of share prices and dividends

Question 8

Property risk premium

Answer 8

A margin to compensate for:

• the risk of default, void
• low marketability and liquidity
• indivisibility
• depreciation
• obsolescence
• volatility of property prices

Question 9

Expected return for a conventional government bond

Answer 9

Gross redemption yield

Question 10

Expected return for a corporate bond

Answer 10

Gross redemption yield

Question 11

Expected return for an equity

Answer 11

Dividend yield + expected dividend growth

Question 12

Expected return for a property

Answer 12

rental yield + expected rental growth

Question 13

When does an asset ‘seem cheap’?

Answer 13

If required return < expected return

Question 14

Simplifying assumptions when equating expected and required return to derive a fair value

Answer 14

• 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

Question 15

Reverse yield gap equation

Answer 15

= gross redemption yield on conventional government bonds
- equity dividend yield
= Inflation risk premium
- equity risk premium
\+ expected dividend growth

Question 16

What can you deduce from the reverse yield gap increasing?

Answer 16

If the assumption about fair pricing is true,
then either:
- the inflation risk premium has increased
- the equity risk premium has decreased
- prospects for equity dividend growth have increased

Question 17

When would an overseas market seem cheap?

Answer 17

If the expected return in the overseas currency
+ expected depreciation of the domestic currency
> expected return in the domestic currency

Question 18

Other methods for assessing whether an asset seems cheap or dear

Answer 18

• yield norms
• index levels
• price charts (technical analysis)
• yield ratios

Question 19

If assets are valued using market values, how would you get a consistent value for the liabilities?

Answer 19

most liabilities are not bought and sold, so a market value does not readily exist.

You could derive a market-related discount rate based on the returns on a set of assets that most closely match the liabilities.