CHP 22

Question 1

1. Expected and required returns

1. 1. Required return

Answer 1

Required return = required risk-free real rate of return + expected inflation + risk premium
The terms on the right hand side are market averages (investors are considered as a class here).
Risk premium on an asset class will be driven by
• Asset characteristics
• Investors’ preference – largely dependent on their liabilities.
The risk premium may cover any adverse feature of one investment relative to another.

Question 2

1.2. Expected return

Answer 2

Expected return = initial income yield + expected capital growth

Question 3

1.3. Required vs expected return

Answer 3

If assets are fairly priced, expected will equal required return.
CAPM is an example of a model that does this.

Question 4

1.4. Determining whether an asset seems cheap

Answer 4

If expected return is higher than what is required in order to hold that asset, the asset appears cheap,

Question 5

2. Analyzing historical returns

Answer 5

In practice, investors in risky assets would not have received the returns they expected. Thus, even if they were fairly valued at the time of purchase, risk premiums cannot be measured by comparing returns on risky assets with risk free.

Question 6

Alternatively, the total asset return on an asset class can be expressed as:

Answer 6

Expected return = initial income yield + income growth + impact of change in yield
Here income growth and change in yield represent capital growth.
When analyzing expected return on an asset class over long periods, one must take account of 
•	Reinvestment of income at different initial yields and 
•	That expected return is expressed as a sum of percentage increases and not a product.(i≈d+g vs. 1+i=(1+g)(1+g))

Question 7

2. Analyzing historical returns

2. 2. Equities

Answer 7

Over long term, equity dividend growth might be expected to be close to growth in GDP, assuming that the share of GDP taken by capital remains constant.
There is a dilution effect due to the need for companies to raise capital when dividends yields are high.
The dilution effect also depends on the extent to which economic growth is generated by start-up companies.
Equities would be expected to give a real return close to the growth in real GDP Plus the equity yield. From historic data this seems to be reasonable – short-term fluctuations are significant and returns depend heavily on timing and tax position.

Question 8

2. Analyzing historical returns

2. 3. Conventional bonds

Answer 8

No income growth.
Analysis of total returns compared with inflation is relatively straight forward:
• In periods where inflation turns out to be higher than expected, real returns from conventional bonds are lower and poor compared to equities.
• In periods when yields are rising, real returns from fixed interest stocks are poor.
The opposites of the above will also hold.

Question 9

2. Analyzing historical returns

2. 4. Index-linked bonds

Answer 9

The real return on these is known at outset, if they are held to redemption. This real yield is often taken as a benchmark required real yield for the analysis of expected returns on equities.
If the bond is sold before redemption, the actual real return will depend on the price for which it is sold – this will depend on supply and demand.

Question 10

2. Analyzing historical returns

2. 5. Cash

Answer 10

Returns on cash might be expected to exceed inflation except when inflation is rising rapidly and is under estimated.
Short-term interest rates can be kept very high or very low by government for significant periods.

Question 11

2. Analyzing historical returns

2. 6. Earnings

Answer 11

A reasonable assumption over the long term is that salaries will increase in line with GDP.