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Valuation of asset classes and portfolios (problems associated with…
Valuation of asset classes and portfolios
required return and expected return formulae
Government bonds
GRY= rf +E(inflation) +IRP (2)
corporate bonds
GRY= rf + E(inflation) +CBRP
equities
d + g = rf + E(inflation) +ERP (1)
property
ry+rg = rf + E(inflation) + PRP
what risk premium reflects
equities
possible default
lower marketability and liquidity
higher volatility of share prices and dividend income
derivation of yield gap and simplifying assumptions
If assets fairly priced, can equate required and expected returns
(2)- (1)
GRY-d-g = IRP-ERP
Rearrange
d-GRY=ERP-IRP-g (yield gap)
Reverse yield gap:
GRY-d= IRP-ERP +g
two sources of variability in an asset portfolio
market movements
a change in the composition of the portfolio for example due to a tactical switch in investment policy
problems associated with volatile asset values (is consistency with the valuation of the liabilities more important?)
volatility affects reality
inconsistency of asset values with liability values
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
alternative is smoothed market value