Portfolio Management - Rate of Return Basics

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.

Formula 17.1
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%.

Answer:

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.

Formula 17.2
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%.

Answer:

Rnominal = (1 + 0.03) x (1 + 0.03) - 1 = 6.09%

The Risk Premium


Related Articles
  1. Investing

    Risk-Free Rate of Return

    The 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 ...
  2. Investing

    Understanding Market Risk Premium

    Market 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 ...
  3. Options & Futures

    How Risk Free Is The Risk-Free Rate Of Return?

    This rate is rarely questioned - unless the economy falls into disarray.
  4. Real Estate

    How Interest Rates Affect Property Values

    Along with their impact on mortgages, interest rates affect capital flows, the supply and demand for capital, and an investor’s required rate of return.
  5. Personal Finance

    Risk-Free & 20% Return? More Like 100% Scam

    An investment that promises a risk-free return of 20% is 100% likely to be a scam.
  6. Economics

    Understanding Interest Rates: Nominal, Real And Effective

    Interest 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 ...
  7. Investing Basics

    How to Calculate Risk Premium

    Think of a risk premium as a form of hazard pay for risky investments.
  8. Fundamental Analysis

    Calculating the Equity Risk Premium

    Equity risk premium is the excess expected return of a stock, or the stock market as a whole, over the risk-free rate.
  9. Options & Futures

    How & Why Interest Rates Affect Futures

    There are at least four factors that affect change in futures prices, including risk free-interest rates, particularly in a no-arbitrage environment.
  10. Investing Basics

    What Investors Should Know About Interest Rates

    Understanding interest rates helps you answer the fundamental question of where to put your money.
RELATED TERMS
  1. Risk-Free Return

    The theoretical rate of return attributed to an investment with ...
  2. Risk-Free Rate Of Return

    The theoretical rate of return of an investment with zero risk. ...
  3. Risk-Free Asset

    An asset which has a certain future return. Treasuries (especially ...
  4. Nominal Interest Rate

    The interest rate before taking inflation into account. The equation ...
  5. Risk-Neutral Measures

    A theoretical measure of probability derived from the assumption ...
  6. Risk Premium

    The return in excess of the risk-free rate of return that an ...
RELATED FAQS
  1. How is it possible for a rate to be entirely risk-free?

    Find out whether there really is such a thing as a risk-free rate of return, and learn why taking the idea of risk-free rates ... Read Answer >>
  2. How is the risk-free rate of interest used to calculate other types of interest rates ...

    Learn how the risk-free rate is used to compare the yields on bonds, and understand how T-bills are used as a proxy for the ... Read Answer >>
  3. What is the correlation between equity risk premium and risk?

    Learn about the relationship between the risk-free rate of return and the equity risk premium, and understand how the risk-free ... Read Answer >>
  4. How is the risk-free rate determined when calculating market risk premium?

    Learn how the risk-free rate is used in the calculation of the market risk premium, and understand why T-bills provide the ... Read Answer >>
  5. What nations other than the U.S. have risk-free interest rates?

    Find out which countries have risk-free rates of returns. This is typically the yield on a 3-month note, and it can be negative ... Read Answer >>
  6. The real rate of return is the amount of interest earned over and above the:

    a. discount rate. b. tax rate. c. inflation rate. d. risk-free rate of return. Answer: C Since the real rate of return measures ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center