Page 82 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 4: Risk and Return

4.3.1 Determinants of the Rate of Return Notes

Three major determinants of the rate of return anticipated 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 said earlier that the rate of return from an investment comprises 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 1
t
t
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, that is, 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 into 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. Calculate 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.
There is invariably a direct association between the rates of return and the asset prices. Finance
theory specifies that the price of any asset is equal to the sum of the discounted cash flows, which

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