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Actual/expected/required returns

J

jonathans

Member
Hi,

This post is based up exam question 2014 april paper 1 question 2.

From examiners report in (i):
"The required return on a conventional bond includes: • Risk free real yield • Expected future inflation • Inflation risk premium • Credit risk premium and liquidity risk premium".

From acted chapter 24 summary:
"Government bonds: risk-free real yield + expected inflation + inflation risk premium".

A. I understand that conventional=government bond?
B. why did the examiner's report add credit risk? they're assuming the bond might of been issued by a less secure government?

From examiners report in (i):
"The actual investment return on equities includes: • income yield (dividends) • capital growth/(falls)".

From acted chapter 24 summary:
"Equities: dividend yield + expected dividend growth".

C. what do they mean by actual return?


Thanks!

Jonathan
 
Conventional bonds are bonds that are conventional in nature so offer a coupon and redeemable on a known date. So it includes government bonds but can be other corporate bonds in there too. So a full definition per the examiners solution is correct. It's just that for most stable governments credit risk is zero. Yes, if a government is unstable or rather its economy is, there is a credit risk of default on payment.

Regarding actual versus expected return it's the difference in viewpoint I think. Are you holding the asset indefinitely or have you actually sold it or intend to having therefore a known dividend stream rather than expected one. So basically it's a question of time horizon.
 
Hi,

Another question: September 2013 paper 1 question 5 part (i):

"ER = Initial income yield + Expected capital growth + (Appreciation of exchange rate of overseas currency over domestic economy)"
"ER = Initial income yield + Expected income growth + Change in yield + (Appreciation of exchange rate of overseas currency over domestic economy)"

Ignoring the overseas part - how is this in anyway consistent with the definition in chapter 24 summary??

Chapter 24 summary:
"Equities: dividend yield + expected dividend growth"
"Property: rental yield + expected rental growth"

Thanks!
 
Just to make sure I got it, they claim that the following definitons are equivalent (due to DCF approach to valuing equities):

d:
dividend yield = Initial income yield + Change in yield

g:
income growth = dividend growth

did I miss anything?

Thanks!
 
That's it. To be super-precise, the "dividend yield" under "d" is the "prospective dividend yield", ie the yield that will be obtained in the future (so it's the initial dividend yield plus the impact of any changes in yield).
Beware; a very great deal of time and effort can be expended on this very small point, and all for very little likely return!
 
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