The Required Rate of ReturnThe required rate of return is the nominal rate of return that an investor needs in order to make an investment worthwhile.
This return varies over time and is comprised of the following:
- Real risk-free rate
- Inflation premium
- Risk premium.
Real risk-free rate of return
The real risk-free rate of return (Rf) is the minimum return an investor requires. This rate does not take into account expected inflation and the capital market environment.
Real risk free rate (Rf) = (1 + nominal risk-free rate) - 1
(1 + inflation rate)
Example: Real risk-free rate of return
Determine the real risk-free rate if the nominal risk-free rate is 8% and the inflation rate is 3%.
Rf = (1 + 0.08) - 1 = 4.85%
(1 + 0.03)
Nominal risk-free rate of return (Rnominal)
This is simply the real risk-free rate of return adjusted for inflation.
Nominal risk-free rate = (1 + risk-free rate) x (1 + rate of inflation) - 1
Example: Nominal risk-free rate of return
Determine the nominal risk-free rate of return if the risk-free rate is 3% and the rate of inflation is 3%.
Rnominal = (1 + 0.03) x (1 + 0.03) - 1 = 6.09%
The Risk Premium
MarketsThe risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free ...
Managing WealthMarket risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
MarketsThis rate is rarely questioned - unless the economy falls into disarray.
Managing WealthAlong with their impact on mortgages, interest rates affect capital flows, the supply and demand for capital, and an investor’s required rate of return.
Financial AdvisorAn investment that promises a risk-free return of 20% is 100% likely to be a scam.
MarketsInterest rates can be broken down into several subcategories that incorporate various factors such as inflation. Smart investors know to look beyond the nominal or coupon rate of a bond or loan ...
Managing WealthThink of a risk premium as a form of hazard pay for risky investments.
InvestingEquity risk premium is the excess expected return of a stock, or the stock market as a whole, over the risk-free rate.
MarketsA real rate of return is an annual percentage investment return that’s adjusted for inflation, taxes or other factors.
MarketsThere are at least four factors that affect change in futures prices, including risk free-interest rates, particularly in a no-arbitrage environment.