Investment required rate of return is the minimum rate of return that investor accept from an investment to compensate investor for deferring consumption. There are three components for the investment required rate of return: the time value of money during the period of investment, the expected rate of inflation during the period, and the risk involved.
The Real Risk Free Rate VS Nominal Rate
The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty about future flows. An investor in an inflation-free economy who knew with certainty what cash flows he or she would receive at what time would demand the RRFR on an investment. Earlier, we called this the pure time value of money, because the only sacrifice the investor made was deferring the use of the money for a period of time. This RRFR of interest is the price charged for the exchange between current goods and future goods.
Nominal rate includes other factors such as inflation and price levels. When talking about investment rate, it is important to distinguish the two rates. Real risk free rate has adjusted for changes in the general price level, as opposed to nominal rates of interest that are stated in money terms. That is, nominal rates of interest that prevail in the market are determined by real rates of interest, plus factors that will affect the nominal rate of interest, such as the expected rate of inflation and the monetary environment. It is important to understand these factors.
Investment Risk Premium
A risk-free investment was defined as one for which the investor is certain of the amount and timing of the expected returns. The returns from most investments do not fit this pattern. An investor typically is not completely certain of the income to be received or when it will be received. Investments can range in uncertainty from basically risk-free securities, such as T-bills, to highly speculative investments, such as the common stock of small companies engaged in high-risk enterprises. Most investors require higher rates of return on investments if they perceive that there is any uncertainty about the expected rate of return. This increase in the required rate of return over the NRFR is the risk premium (RP). Although the required risk premium represents a composite of all uncertainty, it is possible to consider several fundamental sources of uncertainty
Risks Related to Investment Risk Premium
Business risk is the uncertainty of income flows caused by the nature of a firm’s business. The less certain the income flows of the firm, the less certain the income flows to the investor. Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the basic business of the firm. As an example, a retail food company would typically experience stable sales and earnings growth over time and would have low business risk compared to a firm in the auto industry, where sales and earnings fluctuate substantially over the business cycle, implying high business risk.
Financial risk is the uncertainty introduced by the method by which the firm finances its investments. If a firm uses only common stock to finance investments, it incurs only business risk. If a firm borrows money to finance investments, it must pay fixed financing charges (in the form of interest to creditors) prior to providing income to the common stockholders, so the uncertainty of returns to the equity investor increases. This increase in uncertainty because of fixed-cost financing is called financial risk or financial leverage and causes an increase in the stock’s risk premium.
Liquidity risk is the uncertainty introduced by the secondary market for an investment.6 When an investor acquires an asset, he or she expects that the investment will mature (as with a bond) or that it will be salable to someone else. In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investments. The more difficult it is to make this conversion, the greater the liquidity risk. An investor must consider two questions when assessing the liquidity risk of an investment: (1) How long will it take to convert the investment into cash? (2) How certain is the price to be received? Similar uncertainty faces an investor who wants to acquire an asset: How long will it take to acquire the asset? How uncertain is the price to be paid?
Exchange rate risk is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own. The likelihood of incurring this risk is becoming greater as investors buy and sell assets around the world, as opposed to only assets within their own countries. A U.S. investor who buys Japanese stock denominated in yen must consider not only the uncertainty of the return in yen but also any change in the exchange value of the yen relative to the U.S. dollar. That is, in addition to the foreign firm’s business and financial risk and the security’s liquidity risk, the investor must consider the additional uncertainty of the return on this Japanese stock when it is converted from yen to U.S. dollars.