CH:14 Relationship between returns on asset classes

Question 1

What is the formulae for required return

Answer 1

Required return = required risk-free real return + expected inflation + risk premium

Question 2

What is the definition and formulae for expected return

Answer 2

• Expected return is what the investor expects to achieve given the price paid and what is expected to sell the asset as well as the expected income from the asset.

Expected return = initial income yield + expected capital growth
or
= initial income yield + income growth + impact of change in yield

Question 3

What is the condition for required return and expected return to be equal

Answer 3

• The asset to be fairly priced

Question 4

If expected return on equities = long-dated index-linked government bonds + suitable risk premium
List the factors that will be reflected in the risk premium

3

Answer 4

1. differences in marketability
2. uncertainty of income and capital values provided by equity
3. possibility of default on the equity