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s = Standard Deviation
rk = Specific Return
rexpected = Expected Return
n = Number of Returns (sample size).
Correlation
A measure that determines the degree to
which two variable's movements are
associated.
7
Determinants of
Required Returns
The Real Risk Free Rate (RRFR)
Assumes no inflation.
Assumes no uncertainty about future cash
flows.
Influenced by time preference for consumption
of income and investment opportunities in the
economy
Nominal Risk-Free Rate (NRFR)
Conditions in the capital market
Expected rate of inflation
10
Determinants of
Required
Country Risk
Returns
Political risk is the uncertainty of returns caused
by the possibility of a major change in the
political or economic environment in a country.
Individuals who invest in countries that have
unstable political-economic systems must
include a country risk-premium when
determining their required rate of return.
11
Determinants of
Required Returns
Risk Premium and Portfolio Theory
From a portfolio theory perspective, the
relevant risk measure for an individual asset is
its co-movement with the market portfolio.
Systematic risk relates the variance of the
investment to the variance of the market.
Beta measures this systematic risk of an asset.
According to the portfolio theory, the risk
premium depends on the systematic risk.
12
Determinants of
Required Returns
Fundamental Risk versus Systematic Risk
Fundamental risk comprises business risk,
financial risk, liquidity risk, exchange rate risk,
and country risk.
Risk Premium= f ( Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
Systematic risk refers to the portion of an
individual asset’s total variance attributable to
the variability of the total market portfolio.
Risk Premium= f (Systematic Market Risk)
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What does risk free return
mean?
The theoretical rate of return attributed to an
investment with zero risk. The risk-free rate
represents the interest on an investor's money that
he or she would expect from an absolutely risk-free
investment over a specified period of time.
In theory, the risk-free rate is the minimum return
an investor should expect for any investment, as
any amount of risk would not be tolerated unless
the expected rate of return was greater than the
risk-free rate.
In practice, however, the risk-free rate does not
technically exist; even the safest investments carry
a very small amount of risk. Thus, investors
commonly use the interest rate on a three-month
U.S. Treasury bill as a proxy for the risk-free rate
because short-term government-issued securities
What does risk premium
mean?
The return in excess of the risk-free rate of return that
an investment is expected to yield. An asset's risk
premium is a form of compensation for investors who
tolerate the extra risk - compared to that of a risk-free
asset - in a given investment.
Think of a risk premium as a form of hazard pay for your
investments. Just as employees who work relatively
dangerous jobs receive hazard pay as compensation for
the risks they undertake, risky investments must
provide an investor with the potential for larger returns
to warrant the risks of the investment.