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CFA® Level I · Quantitative Methods · free lesson
Returns of Financial Assets and Instruments
Before you can value an asset or judge a manager, you need to know where returns come from and what return investors should demand. This module splits returns into income and price change across the main asset classes, builds a required rate of return from the real risk-free rate, inflation and risk premia, and shows why a change in required returns moves prices immediately.
What you will learn
1. Describe the income and price-change components of return for the main financial assets and instruments, and compare their long-run return and risk characteristics.
- Total return = income return + price return, both measured against the beginning price.
- Equities: dividends plus price change; bonds: coupons plus price change; bills: discount accretion; physical commodities: price change only.
- Price changes, not income, explain most of the short-term variability of returns.
- Price-return indexes exclude income; total-return indexes assume income is reinvested.
- Long-run evidence: equities have beaten bonds, and bonds have beaten bills, in both average real return and volatility, but not in every period.
2. Explain how a required rate of return is built from the real risk-free rate, expected inflation and risk premia, and convert between nominal and real rates.
- Required return is approximately the real risk-free rate + expected inflation + risk premia.
- Nominal risk-free rate is approximately the real risk-free rate + expected inflation; short-term government bills are the usual proxy.
- Default, liquidity and maturity premia compensate for credit risk, marketability and sensitivity to interest rates.
- Exact conversion: (1 + nominal) = (1 + real)(1 + inflation); subtraction is only an approximation.
- Real returns measure the change in purchasing power.
3. Interpret risk premia and the inverse relation between required returns and prices, and explain what changes in credit spreads signal.
- Price = expected cash flows discounted at the required return; required return up, price down.
- Longer-dated cash flows are more sensitive to a change in the required return.
- A jump in required returns hurts realized returns now but raises expected returns from the new price.
- Credit spread = corporate yield - government yield of the same maturity; it mainly reflects default and liquidity premia.
- Spreads widen in downturns and tighten in recoveries.
Module at a glance
- Total return = income return + price return, both divided by the beginning price.
- Equities rely mostly on price change, bonds on coupons plus price change, bills on discount accretion.
- Over long periods equities have earned the most and been the most volatile; bills have earned the least.
- Required return is approximately the real risk-free rate + expected inflation + default, liquidity and maturity premia.
- Use (1 + nominal) = (1 + real)(1 + inflation) for exact conversions.
- Required return up, price down; longer-dated cash flows react more.
- A wider credit spread signals higher required compensation for credit and liquidity risk.
This free module has 3 lessons, 12 practice questions with full explanations.