Chapter 24: Valuation of asset classes and portfolios

Question 1

Expected return on government bonds

Answer 1

Gross Redemption Yield

Question 2

Expected return on corporate bonds

Answer 2

Gross Redemption Yield

Question 3

Expected return on Equities

Answer 3

Dividend yield + expected dividend growth

Question 4

Expected return on property

Answer 4

Rental yield + expected rental growth

Question 5

Required return on Government bonds

Answer 5

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

Question 6

Required return on corporate bonds

Answer 6

risk-free real yield + expected inflation + bond risk premium

Question 7

Required return on Equities

Answer 7

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

Question 8

Required return on Property

Answer 8

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

Question 9

Corporate bond risk premium is needed to compensate the investor for… (3)

Answer 9

• inflation risk
• possible default
• marketability / liquidity

Question 10

Equity risk premium is necessary to compensate the investor for… (3)

Answer 10

• possible default
• marketability / liquidity
• volatility of share prices and dividend income

Question 11

Property risk premium is needed to compensate the investor for… (6)

Answer 11

• possible default
• risk of voids
• lack of marketability / liquidity
• large unit size and indivisibility
• risk of depreciation and obsolescence
• high dealing and management expenses

Question 12

Yield gap

Answer 12

Dividend yield on equities less the gross redemption yield on long-dated government bonds.

Question 13

Reverse yield gap

Answer 13

Gross redemption yield less dividend yield.

GRD - d =
 inflation risk premium 
- equity risk premium
\+ real dividend growth
\+ expected inflation

Question 14

To justify the government bond yields being above equity (dividend) yields, then one or more of (((4))) must hold:

Answer 14

• high uncertainty over future inflation
• a low equity risk premium
• high prospects for real dividend growth
• high expected inflation.

Question 15

2 Main sources of variability of asset values

Answer 15

• short-term market movements

- a change in the asset mix.

Question 16

Expected return equation

Answer 16

Expected return
= initial income yield
+ expected capital growth

Question 17

Required nominal return equation

Answer 17

required nominal return
= required risk-free real yield
+ expected inflation
+ risk premium

Question 18

An overseas market would be considered ““cheap”” if…

Answer 18

expected return in local currency
+ expected depreciation of home currency
> expected return in home currency

Question 19

Define “cheapness”

Answer 19

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

Question 20

Expected vs. Required return:

Simplifying assumptions

Answer 20

• 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

Question 21

Why, historically has the running yield for property been higher than good quality equities? (4)

Answer 21

• 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

Question 22

7 Valuation Methods

Answer 22

Book Value:

• • historical
• • written up / down

Market Value:

• • smoothed
• • fair value
• • arbitrage

Discounted Cashflows

• • deterministically calculated
• • stochastic modelling

Question 23

2 Desirable valuation method features

Answer 23

• Stability over time

- Not sensitive to changes in the investment portfolio (influence of short term investment decisions)

Question 24

To justify PROPERTY YIELDS being ABOVE government bond yields, one or more of the following must hold ((3))

Answer 24

• low expected future inflation
• very low prospects for real rental growth
• justifiably high risk premium for properties

Question 25

3 Other tests of relative value that investment analysts also use from time to time

Answer 25

• yield norms
• index level and price charts
• yield ratios

Question 26

Yield “norms”

Answer 26

For some asset categories, there might be a normal level or range.
When yields are below (above) the normal range, it implies that the asset may be dear (cheap).

Question 27

Index Analysis and Price charts

Answer 27

Technical analysis is sometimes used to compare the value of asset groupings as well as individual assets.

Question 28

Yield ratios

Answer 28

The yield ratio is sometimes used when assessing the relative price of equities and bonds.