Thursday, 19 February 2015

Summary of Required Rate of Return

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Summary of Required Rate of Return


The overall required rate of return on alternative investments is determined by three variables:

(1) The economy’s RRFR, which is influenced by the investment opportunities in the economy (that is, the long-run real growth rate);

(2) Variables that influence the NRFR, which include short-run ease or tightness in the capital market and the expected rate of inflation (notably, these variables, which determine the NRFR, are the same for all investments); and

(3) The risk premium on the investment.

In turn, this risk premium can be related to fundamental factors, including business risk, financial risk, liquidity risk, exchange rate risk, and country risk, or it can be a function of systematic market risk (beta).

1. The measures of risk for an investment are
2. Variance of rates of return
3. Standard deviation of rates of return
4. Coefficient of variation of rates of return (standard deviation/means)
5. Covariance of returns with the market portfolio (beta)

The sources of risk are:

1.Business risk
2.Financial risk
3.Liquidity risk
4.Exchange rate risk
5.Country risk

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