Return on investment

Question 1

What are the pilars for return on investment?

Answer 1

• Time preference rate
• Adjustment for inflation
• Risk premium
• Required rate of return needs to reflect all three component parts

Question 2

What is the Time preference rate?

Answer 2

• Basic return that investors require from any investment
• Time preference rate is same for all investments
• “Opportunity Cost” of investors not being able to use their money whilst it is invested

Question 3

What is required for rate of investment to include inflation?

Answer 3

• Extra return that investors require as compensation for expected fall in purchasing power of their money whilst it is tied up in an investment
• Inflation adjustment is calculated on same basis for all investments
• Fisher Equation

(1+nominal interest rate) = (1 + real interest rate) x (1 + expected inflation rate)

Question 4

Inflation calucation using the Fisher equation

(1+nominal interest rate) =
(1 + real interest rate) x (1 + expected inflation rate)

An investor requires a real rate of return of 3.5% per annum and expects inflation over the next year to be 1.0%. What nominal rate of return do they require from the investment?

Answer 4

An investor requires a real rate of return of 3.5% per annum and expects inflation over the next year to be 1.0%. What nominal rate of return do they require from the investment?

(1+R) = (1+0.035)x(1+0.01)

(1+R) = 1.035 x1 .01

(1+R) = 1.0454

R= 0.0454 or 4.54%

Question 5

What is Risk Premium?

Answer 5

• Extra return that investors require as compensation for uncertainty in amount or timing of expected return on a SPECIFIC investment
• Risk premium varies according to nature and extent of perceived risk of each investment

Question 6

How to quantify Risk Premium?

Answer 6

• What is mean or average expected risk?
• What is the degree of risk that mean return will be achieved in the future?
• Risk is quantified by using probability
• Calculate mean return
• Calculate dispersion of outcomes around mean using variance or standard deviation

Question 7

Limitations of normal distribution?

Answer 7

• Actual returns are not neatly or symmetrically dispersed
• Long run statistical series are quite close to normal distribution
• For practical purposes variance or standard deviation are useful measures of investment risk

Question 8

Which factors are affecting Risk Premium?

Answer 8

• Remember distinction between Debt and Equity
• Risk premium is different between Debt and Equity
• Risk factors:
  
  • Maturity
  • Liquidity
  • Variability of income
  • Default or credit risk
  • Event risk
  • Interest rate risk