Chapter 24: Valuation of asset classes and portfolios Flashcards
Expected return on government bonds
Gross Redemption Yield
Expected return on corporate bonds
Gross Redemption Yield
Expected return on Equities
Dividend yield + expected dividend growth
Expected return on property
Rental yield + expected rental growth
Required return on Government bonds
risk-free real yield + expected inflation + inflation risk premium
Required return on corporate bonds
risk-free real yield + expected inflation + bond risk premium
Required return on Equities
risk-free real yield + expected inflation + equity risk premium
Required return on Property
risk-free real yield + expected inflation + property risk premium
Corporate bond risk premium is needed to compensate the investor for… (3)
- inflation risk
- possible default
- marketability / liquidity
Equity risk premium is necessary to compensate the investor for… (3)
- possible default
- marketability / liquidity
- volatility of share prices and dividend income
Property risk premium is needed to compensate the investor for… (6)
- possible default on rent
- risk of voids
- lack of marketability / liquidity
- large unit size and indivisibility
- risk of depreciation and obsolescence
- high dealing and management expenses
Yield gap
Dividend yield on equities less the gross redemption yield on long-dated government bonds.
Reverse yield gap
Gross redemption yield less dividend yield.
GRD - d = inflation risk premium - equity risk premium \+ expected real dividend growth \+ expected inflation
To justify the government bond yields being above equity (dividend) yields, then one or more of (((4))) must hold:
- high uncertainty over future inflation
- a low equity risk premium
- high prospects for real dividend growth
- high expected inflation.
2 Main sources of variability of asset values
- short-term market movements
- a change in the asset mix.
Expected return equation
Expected return
= initial income yield
+ expected capital growth
Required nominal return equation
required nominal return
= required risk-free real yield
+ expected inflation
+ risk premium
An overseas market would be considered ““cheap”” if…
expected return in local currency
+ expected depreciation of home currency
> expected return in home currency
Define “cheapness”
Expected return (ER) > required return (RR)
Dependent on the views and requirements of individual investor:
- ER function of investor’s view of the future
- – Riskiness of asset
- – Investor’s requirements
- – Matching liabilities
- – Subjective view of the future
Expected vs. Required return:
Simplifying assumptions
- All investors want a real return
- All investors have the same investment time horizon
- Tax differences between investors can be ignored
- Reinvestment is possible at a rate equal to the total expected return on the asset
- Assets are fairly priced
Why, historically has the running yield for property been higher than good quality equities? (4)
- dividends should increase annually, whereas rents are reviewed less often
- dividend arguably have better growth prospects than rents
- property is much less marketable than equities
- property is available only in large, indivisible and consequently inflexible
7 Valuation Methods
Book Value:
- historical
- written up / down
Market Value:
- smoothed
- fair value
- arbitrage
Discounted Cashflows
- deterministically calculated
- stochastic modelling
Two main sources of variability of asset classes
- Short-term market movements
- Change in asset mix
To justify PROPERTY YIELDS being ABOVE government bond yields, one or more of the following must hold ((3))
- low expected future inflation
- very low prospects for real rental growth
- justifiably high risk premium for properties
