Chapter 14: Relationship between returns on asset classes Flashcards
(14 cards)
State the formula for the required return on an asset
The return that investors, as a whole, require on any asset classs can be written as:
Required return = required risk-free real rate of return + expected inflation + risk premium
Discuss the parts of the required return formula
It is assumed that the market defined “risk-free” in real rather than nominal terms.
The risk premium on a particular asset class will depend on the characteristics of the asset and investors’ preferences, which will be largely driven by their liabilities.
A higher return would be required from riskier asset classes. The risk premium may cover any adverse feature of one investment relative to another for which investors require compensation.
State the formula for the expected return on an asset
Expected return = initial income yield + expected capital growth
Approximate expected return = 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 expected return = dividend yield + expected nominal dividend growth
Formula for the expected return on conventional bonds
Conventional bonds = Gross redemption yield (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 of GDP represented by capital remains constant over time
There is, however, a dilution effect due to the need for companies to raise new 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 2 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)