13 - Relationship between return on asset classes Flashcards Preview

CP1 Flashcards > 13 - Relationship between return on asset classes > Flashcards

Flashcards in 13 - Relationship between return on asset classes Deck (10)
Loading flashcards...
1
Q

Required return definition:

A
  • Return that investors as a whole require on any asset class defined as:

Required return = Required risk-free real RoR + Expected inflation + Risk premium

o Terms on RHS of eqn represent mkt. averages as investors are considered as a class here

o Assume market defined risk-free rate in real terms not nominal (usually taken as real yield on index-linked bonds of appropriate term)

2
Q

Required return compensates investors for:

A
  • Inflation so that the value of their assets does not decrease in real terms
  • Compensation for additional risk incurred by undertaking investment
3
Q

What does the required return depend on?

A
  • Investors’ preferences
    o If investor has real liabs, greater risk premium required on assets without inflation protection
  • Characteristics of the assets
4
Q

Expected return definition:

A

Return that investor expects to make on an asset given:

  • Price paid for asset
  • Price for which investor expects to sell/redeem asset
  • Expected income from asset while it is held

This can be broken down as:
Expected returns = Initial income yield + Expected capital growth

5
Q

Definition of fairly priced asset wrt required and expected returns
- What constitutes a cheap asset in this sense?

A
  • Asset is said to be fairly priced when:
    Required return = Expected return
  • Asset is considered cheap when:
    required return < expected return
6
Q

How would we further break down expected capital growth in the expected return formula and how do we obtain this expression?

A

Expected return = Initial income yield + [Income growth + Impact of change in income yield]

Price * Income yield = Income
Price = Income/Income yield
Any change in price (capital gain/loss) is either due to change in income or income yield

7
Q

How is equity growth related to GDP growth?

A
  • GDP growth comes from use of land, labour and capital -: analogous to dividend growth in the company
  • Greater GDP growth usually implies greater revenues, profits & dividends for companies & s/h
  • Long-term dividend growth is expected to be closely in line w GDP growth assuming the capital share of GDP remains unchanged (wary of dilution effect)
  • Hence equities are expected to provide real yield close to GDP growth + equity yield
8
Q

Dilution effect in equities and how it comes about:

A
  • If div. yields are high new shares are issued to raise capital
  • Equity ownership may become dilute => proportion of equity mkt held by s/h decreases
  • Share of dividends received decreases (div yield drops)
  • Dilution also depends on extent to which start-ups generate economic growth
    o If earnings of unquoted companies grow more than quoted companies, share of profits earned by quoted companies decline
    o Dividend growth will be less than GDP growth rate as a result
9
Q

How do the returns of fixed interest bonds fare wrt inflation & interest rate environments?

A
  • If inflation is higher than expected, real return of fixed interest bonds will be lower than expected & poor compared to equities
  • In periods when yields are rising, real returns on FI bonds will be worse than expected (this is particularly true if the bond is sold before maturity)
10
Q

Why may an investor NOT receive the GRY even after holding the FI bond to maturity?

A
  • The borrower has defaulted on either the redemption or interest payments
  • Impact of tax, dealing costs or exchange rate changes
  • Coupons may have been reinvested at rates that differ from the quoted GRY