Determinants of required rate of return, Finance Basics

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Determinants of Required Rate of Return

1.Risk free rate - This is the interest rate such would exist on default free securities like Treasury bills and bonds.

Risk free rate is made up of two components like:

  1. Real rate of return -if there was no inflation, interest rate
  2. Inflation premium

Therefore risk free rate (RF) = Real rate of return + Inflation premium.

If risk premium is added to risk free rate, necessary rate of return is derived. Hence required rate of return = real rate + inflation + premium + risk premium = Risk free rate + Risk premium.

2. Inflation premium - Investors are compensated for reduction in purchasing power of money.  From point (1) the higher such the inflation premium, the higher the market interest rate.

3. Default risk premium (DRP) - This is the rate further added to risk free rate for possibility of default in such payment of loans.  Generally, it's added if two securities have equal marketability and maturity.

4. Liquidity premium - This is premium that is added to equilibrium interest rate on a security if such type of security cannot be transformed to cash on short notice and close to the original cost.

5. Maturity Risk Premium - a premium reflecting interest rate risk that is risk of capital losses that investors are exposed to due to hanging interest rate over time.


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