Question

What effect do increasing inflation expectations have on the required returns of investors in common stock?

Explain the specific relationship between risk and reward and why this relationship must be true.

Answer 1

Inflation refers to the situation in which there is sustained increase in prices of goods and services leading to decline in people’s purchasing power. Due to inflation, the value of money decreases over time. This means that the value of Rs. 1,00,000 held with you as idle money will fall in value in future. Assuming an inflation rate of 7% per annum, the value falls by 86.86% in 30 years. This leads to a reduction in returns realized from our investments. While we are under the impression that we have realized extraordinary returns, when accounted for inflation, most investments like Fixed Income and Gold rarely create wealth. Real return is the difference between nominal return and inflation. Inflation erodes the pricing power and is the consumer's greatest enemy. Inflation hurts consumers more than savers. Most investors get lured in by the nominal rate of return, and do not look at the real rate of return. Inflation erodes their savings silently.

As inflation increase people start investing more money in gold rather than depositing their money in bank or stock market because of the lower net interest rate .We understand this phenomeno with this case-

Case- Let A person X deposit Rs 100 in bank interest rate let say 10% per annum .After the end of year he draw his money from bank and get Rs 110 ,he buy 10 kg potato @105 RS .This time he remain 5 rupees .In next year he again deposit Rs 100 and at the end of that year he get same Rs 110( Because in general banks keep interest rate same at deposit ) ,now he buy 10 kg potato @108 RS (the change in price due to inflation ) this time he remain only RS .The margin of interest rate given bank at deposit and inflation is called net interest rate .As the inflation increase the net interest rate decrease (net interest rate =interest rate given by bank - inflation) means the remaining Rs are decrease in above example .So people don't like to deposit money in bank and stock market .They go for other options like as gold .

Due to unexpectency of inflation people try to escape from investing money in stock market .In high inflation the rate of stocks increase and there is more chance of lowering this rate in future due to reduction in inflation ( inflation is biggest tool of monetary policy ,central bank always try to keep inflation within a limit). In expected inflation people invest more in stock market .

there are high return, low-risk investments. These usually involve hedging - competitive pricing is one such tactic, where we take two similar companies/direct competitors (equities will allow greater returns), long the underpriced stock, and short the overpriced stock. This minimizes risk, because if one of those companies does not work out to our liking, the other investment usually covers it.

But for the most part, high risk is associated with high reward. This brings me to the equities market, in these companies we own a piece of the company for every share purchased. Therefore, we can sell at any time, and are also entitled to dividends, ergo, higher returns.

Private equity/venture capital is probably the highest risk/reward. With this strategy, investors look for new, promising companies in their early stages. These companies are private - meaning they are not traded on a public exchange. Usually, the investors, whether they be angel investors, venture capitalists, etc.; will fund the company in a series financing after a valuation, and receive a lucrative percentage of equity or ownership within the company. Say, a company is valuated at $20M, and the investors decide to give them $10M for 50% of the company. If the company grows to 40M over a few years, you just turned 10M into 20M over a few years. You just doubled your money over a few years; however, many of these companies also fail because they are in their early stages, and success is usually uncertain w/o good management, etc.

Bonds are fixed income, meaning low risk, low-reward. Usually returns a fixed rate each year (usually very low), no dividends, and it takes years to mature. However, these are instruments of debt are usually guaranteed by the issuer.