Ch 14: Relationship between returns on asset classes Flashcards
State the formula for the required return on an asset
Required Return = risk free return + expected inflation + risk premium
State the formula for the expected return on an asset
Expected return = initial income yield + expected capital growth
Approx = initial income yield + income growth + impact of change in yield
What does it mean if the required return equals the expected return?
The assets are ‘fairly priced’
What does it mean if the required return for an investor is less than the expected return
The asset appears cheap for that investor
Formula for the expected return on equities
Equities = dividend yield + expected nominal dividend growth
Formula for the expected return on conventional bonds
Conventional bonds = GRY (nominal)
Formula for the expected return on index linked bonds
Index linked bonds = GRY (real)
Formula for the expected return on property
Property = rental yield + expected nominal rental growth
Formula for the expected return on cash
Cash = short term nominal interest yields
Over the long term, what is equity dividend growth expected to be close to?
It might be expected to be close to economic growth (growth in GDP), but this assumes that the share pf GDP represented by capital remains constant over time.
There is, however, a dilution effect due to the need for companies to raise new equity capital from time to time if dividend yields are high.
The dilution effect also depends on the extent to which economic growth is generated by start-up companies.
Give two examples of when real returns on conventional bonds will be poor.
- In periods when inflation turns out to be higher than expected.
- In periods when yields are rising, real returns from fixed interest stocks are poor.
Discuss the factors affecting the expected return on cash
Returns on cash might be expected to exceed inflation except in periods where inflation is rising rapidly and is under-estimated by investors.
Short-term interest rates can also be kept very high or very low by governments for significant periods.
Over the long term, what are wages expected to grow in line with?
A reasonable assumption will be growth in line with GDP (i.e. economic growth)