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CFA Level II Exam · Economics and Investment Markets

How to Forecast Asset Class Returns in CFA Level II

Updated 7 October 2026 · Fact-checked

Forecasting asset class returns means estimating expected returns for bonds, equities and real estate. You use three approaches: discounted cash flow (yield plus growth, such as the Grinold-Kroner model), risk premium (risk-free rate plus premiums, such as bond building blocks), and equilibrium (CAPM-style). In the exam, pull the inputs from the vignette and add the components.

Understand Forecasting Asset Class Returns

A forecast of an asset class return is an estimate of the long-run return you expect from holding that asset class. Portfolio managers use it to set strategic asset allocation. The exam tests whether you can pick the right approach and add up the components correctly from the vignette data.

There are three families of method. The discounted cash flow (DCF) approach treats the expected return as the discount rate that equates price to expected cash flows. In practice it is income yield plus expected growth. The risk premium approach builds the return as a risk-free rate plus one or more premiums for the risks you bear. The financial market equilibrium approach assumes markets are priced so that expected returns match risk, for example through CAPM, where the risk premium depends on beta.

For fixed income, the usual tool is a building-block view. Start with the yield to maturity. Add the rolldown return, which is the price gain from the bond moving down a upward-sloping curve as time passes. Add any price change you expect from a view on yield changes. Subtract expected credit losses. Add expected currency gains or losses if the bond is in a foreign currency.

For equities, the Grinold-Kroner model splits the expected return into an income return, a nominal earnings growth return and a repricing return. For real estate, a simple DCF view uses the capitalisation rate (first-year net operating income divided by price) plus expected growth in income. You can also use a risk premium view: risk-free rate plus a real estate premium.

The key skill is to match each number in the vignette to a component. Do not double count. Yield already includes income. Growth should be in the same terms (nominal or real) as the other terms.

Key formulas to remember

Grinold-Kroner expected equity return
E(Re) ≈ D/P − %ΔS + i + g + %ΔP/E
D/P is the dividend yield, %ΔS is the percentage change in shares outstanding (so −%ΔS is the net repurchase yield), i is expected inflation, g is real earnings growth, %ΔP/E is the annualised repricing return. It is an approximation.
Components of the Grinold-Kroner model
Income return = D/P − %ΔS; Nominal earnings growth = i + g; Repricing return = %ΔP/E
The three parts you add. Check each one against the vignette before summing.
Simple DCF (Gordon) equity return
E(Re) = D1/P0 + g
Assumes dividends grow at a constant rate g indefinitely and that the required return exceeds g.
Bond expected return building blocks
E(R) ≈ YTM + rolldown return + E(price change from yield view) − E(credit losses) + E(currency gain or loss)
Rolldown return is the price gain from moving down the curve with the curve unchanged. Use only the terms the vignette gives.
Price change from a yield view
%ΔP ≈ −ModDur × ΔY + ½ × Convexity × (ΔY)²
Use when you expect yields to change. A yield rise gives a negative first term.
Risk premium (build-up) approach
E(R) = Rf + risk premium(s)
For bonds the premiums can be term, credit and liquidity. For equities it is the equity risk premium.
Equilibrium (CAPM) expected return
E(Ri) = Rf + βi × [E(RM) − Rf], with βi = σi × ρ(i,M) ÷ σM
Beta rises with the asset's volatility and its correlation with the market. Use the global market in an integrated market and the local market in a segmented market.
Real estate DCF view
E(R) ≈ cap rate + expected NOI growth, where cap rate = NOI1 ÷ P0
An approximation that assumes a stable cap rate and no change in leverage.

How to solve Forecasting Asset Class Returns questions

Use this order for any item-set question on forecasting asset class returns. Most marks are lost by mismatching inputs, not by hard maths.

  1. 1Read the question stem first. Identify the asset class (bond, equity or real estate) and the approach asked for (DCF, risk premium or equilibrium).
  2. 2Scan the vignette and exhibits for the inputs. Mark yield, growth, inflation, share count change, P/E levels, credit loss and currency data.
  3. 3Write down the matching formula. For equities use Grinold-Kroner. For bonds use the building blocks. For real estate use cap rate plus growth.
  4. 4Check units. Make sure growth is real if inflation is added separately (or use nominal growth with no extra inflation term), and that any multi-year P/E change is converted to an annual rate.
  5. 5Compute each component on its own. For rolldown, price the bond at its shorter maturity on the unchanged curve and compare with its price at the original yield.
  6. 6Check signs. Credit losses reduce return. A falling share count adds return. A falling P/E subtracts return.
  7. 7Add the components and compare with the answer options. Check if the question wants a risk premium, in which case subtract the risk-free rate.
  8. 8Sense-check the answer. A long-run equity return of 25% or a bond return far below its yield signals an input error.

Quickest way: Component checklist

When to use it: Use when time is short and the vignette lists the inputs clearly, such as a Grinold-Kroner or bond building block question.

  1. Write the formula skeleton with blanks: yield + growth + repricing for equities; YTM + rolldown − losses for bonds.
  2. Fill each blank directly from the vignette and cross it off.
  3. Do the one calculation that needs work, usually rolldown price or annualised P/E change.
  4. Add the pieces. Eliminate options that miss the sign of the repricing or credit loss term.
  5. If the question asks for a risk premium, subtract the risk-free rate last.

Common mistakes in Forecasting Asset Class Returns

  • Using the wrong sign on the share count term in Grinold-Kroner.

    The formula shows −%ΔS, and students add the share change instead of subtracting it.

    Fix: If shares outstanding fall by 0.5% a year, %ΔS = −0.5%, so −%ΔS adds +0.5% to the return. Call it the net repurchase yield.

  • Using the total P/E change over several years as the annual repricing return.

    The vignette gives start and end P/E, and students compute the one-off percentage change.

    Fix: Convert to an annual rate: (P/E end ÷ P/E start)^(1/n) − 1. Then add it.

  • Calling the bond's YTM its expected return.

    YTM is quoted prominently and looks like a return.

    Fix: YTM is only the starting point. Add rolldown and any yield-change view, then subtract expected credit losses and adjust for currency.

  • Computing rolldown against the wrong price.

    Students compare the future price with the coupon or with the original purchase price at a different yield.

    Fix: Compare the end-of-horizon price on the unchanged curve with the end-of-horizon price at the original YTM, divided by the starting price. For a par bond this equals the new price minus 100, over 100.

  • Mixing real and nominal growth.

    Real earnings growth and inflation are given separately and students add only one, or add inflation twice.

    Fix: Nominal earnings growth is i + g. Use it once, and never add another inflation term on top.

  • Confusing DCF with risk premium approaches.

    Both give a return, and both use a yield.

    Fix: DCF builds return from cash flows (income plus growth). Risk premium builds it from a risk-free rate plus compensation for risk. Equilibrium links the premium to beta.

Worked examples

Example 1

Vignette: A fixed income analyst reviews a 3-year, 4.00% annual-coupon government bond priced at par (YTM 4.00%). She assumes the yield curve stays unchanged over the next year. On the current curve, a 2-year bond yields 3.50%, so in one year this bond, with two years left, will trade at a yield of 3.50% (the rolldown yield). She assumes no further view on yield changes. She estimates expected credit losses at 0.30% a year and no currency effect. Questions: (1) What is the rolldown return? (2) What is the expected one-year return using the building block approach?

Show the solution
  1. Because the curve is unchanged, the bond's yield in one year is the 3.50% yield of a 2-year bond on today's curve. No separate yield-change view is added.
  2. Price in one year at 3.50% with two years left: 4 ÷ 1.035 + 104 ÷ 1.035².
  3. 4 ÷ 1.035 = 3.8647. 1.035² = 1.071225, so 104 ÷ 1.071225 = 97.0850.
  4. Price = 3.8647 + 97.0850 = 100.9497.
  5. Price at the original YTM of 4.00% with two years left would be par, 100, because the bond is a par bond.
  6. Rolldown return = (100.9497 − 100) ÷ 100 = 0.95%. This is the price gain only.
  7. Expected return ≈ YTM + rolldown − credit losses = 4.00% + 0.95% − 0.30% = 4.65%. The building block sum is an approximation of the expected return, because it adds the components instead of compounding them.

Answer: (1) Rolldown return is about 0.95%. (2) The expected one-year return is approximately 4.65%.

Example 2

Vignette: An equity strategist forecasts the return on a developed market index over five years. The dividend yield is 2.2%. Shares outstanding are expected to fall by 0.5% a year through net buybacks. Expected inflation is 2.0% and real earnings growth is 2.5%. The P/E is expected to fall from 20 to 19 over the five years. The risk-free rate is 3.0%. Questions: (1) What is the expected income return? (2) What is the annualised repricing return? (3) What is the expected equity return and the implied equity risk premium?

Show the solution
  1. Income return = D/P − %ΔS = 2.2% − (−0.5%) = 2.7%.
  2. Nominal earnings growth = i + g = 2.0% + 2.5% = 4.5%.
  3. Repricing return per year = (19 ÷ 20)^(1/5) − 1 = 0.95^0.2 − 1 ≈ −1.02%.
  4. E(Re) ≈ 2.7% + 4.5% − 1.02% = 6.18%.
  5. Implied equity risk premium = 6.18% − 3.0% = 3.18%.

Answer: (1) Income return is 2.7%. (2) Repricing return is about −1.02% a year. (3) Expected equity return is about 6.18%, giving an implied equity risk premium of about 3.18%.

Exam tips

  • Expect the vignette to hand you most of the Grinold-Kroner inputs. The test is whether you annualise the P/E change and get the share count sign right.
  • For bond questions, do the rolldown price calculation first. It is the step that needs a calculator and the one most options differ on.
  • When a question asks which approach fits, remember: yield plus growth is DCF, risk-free plus premium is risk premium, beta-based is equilibrium.
  • Check whether the stem asks for a total return or a premium over the risk-free rate before you pick an option.
  • Watch for statements that assume the P/E or cap rate stays constant. Those mark the model's key limitation, which is often tested.

Forecasting Asset Class Returns: frequently asked questions

What is the Grinold-Kroner model?

It is a DCF-style model that breaks expected equity return into income, nominal earnings growth and repricing. The approximation is E(Re) ≈ D/P − %ΔS + i + g + %ΔP/E. You add the components given in the vignette.

What is the difference between the DCF and risk premium approaches?

The DCF approach builds the return from cash flow yield and expected growth. The risk premium approach starts at the risk-free rate and adds premiums for the risks of the asset. Both can give similar answers, but the inputs differ.

How do I find the building block return for a bond?

Start with YTM and add the rolldown return. Add any price change you expect from yield moves, then subtract expected credit losses and adjust for currency if relevant. Use only the items given in the vignette.

How do I treat a multi-year P/E change?

Convert it to an annual rate using (P/E end ÷ P/E start)^(1/n) − 1. Then add that annual figure as the repricing return. Using the total change over the period overstates the effect.