15. C is correct. The discount rate for real estate includes a liquidity premium as it can take time
to enter or exit real estate at its fair value. Real estate returns also include a premium for risk
which is similar to an equity risk premium as their value is affected by a host of economic
factors. Real estate values are sensitive to economic cycles. Section 7. LO.m.
Set 2 Questions
The following information relates to questions 1 - 3.
Abe Harold, an equity analyst has recently joined Greenfield Advisers, a global economic
consulting firm that provides economic updates of the global economy, and forecasts the
macroeconomic variables impacting various financial markets. Cathy Huang, Harold’s
supervisor knows that he is still relatively new to macro forecasting models, therefore discusses
with him macroeconomic variables used in forecasting models. Huang first questions him about
the key components of a discount rate. Harold responds, “The uncertainty about future cash
flows is indicated in the discount rate which is composed of three components:
I. The return required by an investor on a real default-free fixed-income security analogous
to the expected return on an inflation-linked bond issued by a developed economy
government.
II. The additional return required for investing in a real default-free investment.
III. The additional premium required to compensate for the uncertainty about the asset’s
future cash flows.”
Huang then shows Harold some of the factors (refer to Exhibit 1) that influence a country’s
economic cycle and how they affect policy interest rates and fixed-income markets.
Exhibit 1: Important Economic Observations
Country Factors
China An aggregate increase in borrowing
Positive output gap
USA Volatile inflation expectations
Increasing equity risk premiums
Japan Increase in marginal utility from consumption
Increase in individual saving levels
Huang next asks Harold, about the relationship of current interest rates with inflation
expectations. Harold explains, “The difference between yields on a default-free real bond and a
default-free nominal bond of the same maturity reflects both future inflation expectations of
investors plus a risk premium for the uncertainty of future inflation.”
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