Page 71 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Personal Financial Planning

Notes 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.

Determinants of the Rate of Return

Therefore, three major determinants of the rate of return expected by the investor are:
(i) The time preference risk-free real rate
(ii) The expected rate of inflation
(iii) The risk associated with the investment, which is unique to the investment.

Hence,
Required return = Risk-free real rate + Inflation premium + Risk premium

Self Assessment

Fill in the blanks:
1. Return includes the interest, dividend and………………………………; while risk represents
the uncertainty associated with a particular task.

2. Risk and expected return are the two key determinants of an ……………………….decision.
3. The risk and return are …………………………..variable.
4. ………………………rate of return on a risk-free asset is equal to the time preference real
rate plus expected inflation rate.
5. …………………are more volatile and riskier than bonds.

4.4 Risk Free and Risky Assets

Two basic investment avenues are:
(i) Financial assets
(ii) Physical assets (real assets)
Investment in financial assets consists of:
(a) Securitized (i.e., security forms of) investments
(b) Non-securitized investments.

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