Page 73 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes invest in such assets, an additional compensation, called the risk premium will have to be paid
over and above the nominal rate of return.
Determinants of the Rate of Return
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 ]
t
t
t-1
Rate of return (R ) = ...(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 - P t-1
t
Rate of return (R ) = + ...(2)
t P t-1 P t-1
I t
Where, is called the current yield,
P
t 1
P - P t-1
t
and is called the capital gain yield.
P t-1
Or ROR = Current yield + Capital gain yield

Example: The following information is given for a corporate bond. Price of the bond at
the beginning of the year: 90, Price of the bond at the end of the year: 95.40, Interest received
for the year: 13.50. Compute the rate of return.
Solution: The rate of return can be computed as follows:

13.50 +(95.40 - 90)
= 0.21 or 21% per annum
90
The return of 21% consists of 15% current yield and 6% capital gain yield.

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