An Australian investor currently holds anA$240 million equity portfolio. He is c

Question

An Australian investor currently holds anA$240 million equity portfolio. He is considering rebalancing the portfolio based on an assessment of the risk and return prospects facing the Australian economy. Information pertaining to the Australian investment markets and the economy has been collected in the following table Capital Market Expectations 10-Year Historical Current 10-yr govt bond yield: 10-yr avg govt bond yield: 6.6% Avg annual equity return: 7.3% Avg annual inflation 5.6% Year-over-year equity return: 2.6% Expected annual inflation: 3.5% Year-over-year inflation rate: 2.6% rate: 3.3% Capital Market 10-Ycar Historical Current Current equity market Equity market P/E (beginning of equity market P/E: 14.5X P/E: 14.0X 15.0X Expected annual income Avg annual income return : 2.0% return: 1.5% Avg annual real earnings Expected annual real growth: 6.0% carnings g 5.0% TASK: Using the information in the table, address the following problems: A. Calculate the historical Australian equity risk premium using the bond-yield plusrisk-premium method B. Calculate the expected annual equity return using the Grinold-Kroner model (assume no change in the number of shares outstanding) C. Using your answer to Part B, calculate the expected annual equity risk premium

Explanation / Answer

10-year Govt. bond yield = 6.60%

Avg. Annual equity return = 7.30%

A. Risk Premium = Avg. Annual equity return - 10 year Govt bond yield r= 7.30% - 6.60% = 0.70%

B. Dividend yield = 0

Expected inflation = 3.50%

g(Real growth rate in earnings) = 5%

S (Changes in shares outstanding) = 0%

Delta(P/E) = (14-14.5)/14.5 = -3.45%

Expected return = 5.05% (Add everythinf from above)

C. Expected annual equity Risk premium = Expected equity return - current govt. bond yield = 5.05% - 5.60%

= -0.55%

Negative value indicates that probably one should sell their shares.

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