Chapter 14: Relationship between returns on asset classes Flashcards
What is required return and what are the three components comprising it?
Required return is the return investors require from an asset before investing in an asset
RR = risk-free real return + expected inflation + risk premium
risk-free real return is often the return on an index-linked bond
What are the main risks in the equity market to be included in the equity risk premium
- Default
- Volatility of dividends
- Marketability and liquidity (particularly for smaller sized / unquoted companies)
What are the main risks in the equity market to be included in the conventional government bond risk premium
- Inflation (inflation risk premium)
What are the main risks in the equity market to be included in the corporate bond risk premium
- Inflation risk
- Default risk (depends on credit rating)
- Marketability and liquidity
What are the main risks in the equity market to be included in the property risk premium
- Voids risk
- Volatility of commercial property prices
- Marketability
What is expected return and what are two components comprising it?
Expected return based on current prices and income stream
Expected return = Initial income yield + Expected capital growth
What is the expected return in the equity market?
Initial income yield: Dividend yield (Dividend/Price paid)
Expected capital growth: Expected inflation + Expected dividend growth
What is the expected return in the government and corporate bond market?
Gross Redemption Yield
What is the expected return in the government and property market?
Initial income yield: Rental yield (Rent/Price paid)
Expected capital growth: Expected inflation + Expected rental growth
If an asset is:
> fairly valued RR ? ER
> cheaply valued RR ? ER
> expensively valued RR ? ER
> fairly valued RR = ER
cheaply valued RR < ER
expensively valued RR > ER
