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Valuation of asset classes and portfolios (volatility a problem?…
Valuation of asset classes and portfolios
If the required return is less than the expected return, the asset seems cheap
Formulae equating expected and required returns
Government bonds
GRY= rf + E(inflation) + IRP (2)
Corporate bonds
GRY=rf + E(inflation) +CBRP
Equities
d + g= rf + E(inflation) + ERP (1) (4)
Property
ry + rg = rf + E(inflation) + PRP (3)
Equity risk premium
yield margin over and above government bond yields that is needed to compensate the investor for
possible default
lower marketability
lower liquidity, e.g. due to volatility of asset values
uncertainty of dividend income
yield gap
(1) - (2)
d- GRY = ERP - IRP -g
reverse yield gap
GRY -d = IRP - ERP + g
reasons for a higher than normal reverse yield gap
(if assets are fairly priced)
investor's perceptions of inflation risk have increased
investors' perceptions of the riskiness of equities have reduced
investors' expectations for real dividend growth have increased
investors' expectations for inflation have increased
reasons for a higher than normal reverse yield gap
(if assets are not fairly priced)
government bonds may be cheap relative to equities
comparison of rental and dividend yields
(3) - (4)
ry - d = PRP- ERP - rg + g
reasons for a higher than normal yield gap
(if assets are fairly priced)
investor's perceptions of the riskiness of equities have reduced
investors' perceptions of the riskiness of equities have reduced
investors' expectations for real dividend growth have increased
investors' expectations for property risk have increased
reasons for a higher than normal reverse yield gap
(if assets are not fairly priced)
property may be cheap relative to equities
when an overseas market seems cheap
expected return in local currency + expected depreciation of home currency > expected return in home currency
other methods used for establishing cheapness or dearness of assets
Yield norms
Index levels and price charts (technical analysis)
Yield ratios (used for equities and bonds)
methods of valuing assets and liabilities consistently
discounted cashflow approach (use interest rate which represents the long-term expected return on the assets)
Market value
Difficult since not frequently traded
Determine market related discount rate (discount rate can be taken as the return on a portfolio of assets that most closely replicate the liabilities)
reasons for a volatile asset valuation
market movements
a change in the composition of the portfolio for example due to a tactical switch in investment policy
volatility a problem?
volatility reflects reality
inconsistency of asset values with liability values is a problem, if the latter are calculated using a stable, long-term discounted cashflow method
However, an unstable asset value is hard to communicate
Valuing liabilities on a consistent "market-related" basis is hard to achieve (i.e. the discount rate is hard to determine)