Page 72 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 4: Risk and Return Analysis

of return expected by an investor from a risk-free capital asset assuming a world without Notes
inflation. However, in real life, inflation is a common feature of a capitalist economy. If
the investor is not compensated for the effects of inflation, the real rate of return may turn
out to be either zero or negative. Therefore, the investors, generally, add expected inflation
rate to the real rate of return to arrive at the nominal rate of return.
For example, assume that the present value of an investment is 100; the investor expects
a real time rate of 3% per annum and the expected inflation rate is 3% per annum. If the
investor was to receive only the real time rate, he would get back 103 at the end of one
year. The real rate of return received by the investor would be equal to zero because the
time preference rate of 3% per annum is matched by the inflation of 3% per annum. If the
actual inflation rate is greater than 3% per annum, the investor would suffer negative
returns.

Thus, nominal rate of return on a risk-free asset is equal to the time preference real rate
plus expected inflation rate.
If the investment is in capital assets other than government obligations, such assets would
be associated with a degree of risk that is idiosyncratic to the investment. For an individual
to invest in such assets, an additional compensation, called the risk premium will have to
be paid over and above the nominal rate of return.

4.4 Determinants of the Rate of Return

Caution Therefore, three major determinants of the rate of return expected by the investor
are:
1. The time preference risk-free real rate
2. The expected rate of inflation
3. The risk associated with the investment, which is unique to the investment.

Hence,
Required return = Risk-free real rate + Inflation premium + Risk premium
It was stated earlier that the rate of return from an investment consists of the yield and capital
appreciation, if any. The difference between the sale price and the purchase price is the capital
appreciation and the interest or dividend divided by the purchase price is the yield. Accordingly
I +[P – P ]
Rate of return (R ) = t t t–1 ...(1)
t P
t–1
Where R = Rate of return per time period 't'
t
I = Income for the period 't'
t
P = Price at the end of time period 't'
t
P = Initial price, i.e., price at the beginning of the period 't'.
t-1
In the above equation 't' can be a day or a week or a month or a year or years and accordingly
daily, weekly, monthly or annual rates of return could be computed for most capital assets.

The above equation can be split in to two components. viz.,
I t P t - P t–1
Rate of return (R ) = + ...(2)
t P P
t–1 t–1

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