Required Rate of Return

Table of contents

It is a process that refers to laying aside of some amount of money for the purposes of deriving profit in the future. It mostly applied by the firms and government when they want to acquire capital goods that allow the increased production of the consumer goods and services in the future time periods.

Required Rate of Return

It is the rate of return that is needed to induce the investors or companies to invest in something in an organization. It is the discounted cash flow analysis that is above an investment that is to be carried out and that which is below that it does not and is based on the firms cost of capital or the weighted average cost of capital plus or minus a risk premium that reflects the project risk characteristics.

Risk-free rate of return

It refers to the minimum return as investor expects from any investment since he or she will not accept additional risk that is related to an investment unless the potential rate of return is greater than the risk-free rates. It usually represents the interest an investor would expect from an absolutely risk-free investment that takes place over a specified period of time.

Fundamental risk

It refers to the exposure that an investor is exposed to mostly as a loss from a situation that affects a large group of people or firms that are caused by natural phenomenon such as earthquake, flood, hurricane or the social phenomenon such as inflation, unemployment and ware. They may be insurable or not insurable.

Systematic Risk

It is also referred to as the un-diversifiable or the market risk. It is the risks can affect the entire market and it cannot be avoided through diversification, but can be mitigated through hedging. The different sources of systematic risks are interest rates, recession and hours. The value of investments may decline over a given period simply because of the economic changes or the other events that impact on the large portion of the markets.

Equity investment

It refers to the buying and selling of shares of stock in the stock market by the individuals and the funds in the anticipation of the income in form off the dividends and capital gain as the value of stock increases.

Fixed income investments

It is a type of security that pays a fixed rate of return and it offers protection against market risk, but it does not protect the holders of the securities against the risk such as inflation. It involves securities such as bond or preferred stock.

Option investment

The option is a derivative security whose value is determined by the underlying issues which may be either common stock or index and it’s widely followed by the baskets of stocks. The choice of the best investment option depends on the personal circumstances such as the general market conditions. For example a good investment for a long term investment retirement plan may not be appropriate for the higher education expenses.

Market index

It is an index that is designed so as to measure the changes of price on the overall market such as the stock market or the bond market. It is used to determine the trend in which security market are following in a given period of time.

Markonitz portfolio theory

It is a theory that relies on a number of assumption that regard the investor behavior towards the way he views investment portfolios such that when an investor is presented with a wide spectrum of alternatives, the investors will consider all the expected rates of return over a specified holding period. It also examines the efficient frontier curve that shows a set of portfolio that offer maximum rate of return for any given level of risk.


It is a portfolio strategy that is used to reduce the exposure of risk this done by combining a variety of investments such as stocks, bonds and the real estate that are unlikely to move in any direction that an investor expects. The diversification reduces the upside and down side potential of the investment securities and it allows for more consistent performance over a wide range of the economic conditions.

Standard deviation

It is a measure of dispersion of outcomes around the means or the expected values that are used to measure risk that an investment may in incur in the future.

It is also referred to as the square root of the variance of the variables of an investment and the spread of the data about the mean values. It is used to compare sets of data that have the same mean but a different range.


It is a random variable that is used to measure the statistical dispersion that indicates how far from the expected value is from the typically values

a. It is also used to scale or the degree in which a spread takes place for different variables of an investment.


It refers to the measure that is used to determine the degree to which the returns of two variables are in tandem or how the two values change over a given period of time. The positive covariance refers to the asset returns move together while the negative covariance means that asset returns vary inversely.


It refers to the measure that is used to determine the degree of association between two variables such as x and y that vary between negative 1 and positive one values. It is also used to measure the statistical relationship that exists between two comparable time series. Part 2 1. The reasons why the bond market indices are more difficult to construct and to maintain than the stock market indices. The bond market index is an index that is used to list bonds or fixed income instruments and a statistic that reflects the composite value of its components. It also used to represent the characteristics of its components fixed income instrument. The bond market index differs from the stock market indices on the basis of their complexity of the indices.

They are also categorized on the basis of their broad characteristics such as government bonds, corporate bonds, high-yield bonds and the mortgage-backed securities. They are harder to replicate as compared to the stock market indices; this is because the average direction of the market may not be appropriate for a given portfolio within a given period of time. The replication can be achieved through using the bond future to match the duration of the bond index. The stock market index is an index that is used to measure the stock market as a whole.

The indices are derived from news or the financial service news and they can be used as the benchmark for the performance of the portfolio such as mutual funds. They may be classified into indexes that are referred to as broad base index that is used to represent the performance of the whole stock market and by proxy it represents the investor sentiments on the state of the economy.

The difference between price-weighted and value weighted index and how they adjust for the stock splits. The price weighted index is a stock market index that has constituents that make a fraction of the fraction index that is proportional to its price.

Its development may not accurately reflect the evolvement of the underlying market values this is because $100 stock may be used for a small company and $10 stock may be for a larger company. The change in price that is quoted for a small company will make up the price weighted index. The market value weighted index is the index that has its stock being affected by the index that is proportional to its market value. It also has its components weighted according to the total market value of its outstanding shares.The stock split refers to the company’s board of directors to increase the number of shares that are outstanding is done by issuing more shares to the current shareholders. The stock prices are affected by the stock split since after the split the stock prices are reduced since the numbers of shares outstanding have been increased. They are usually done to companies that have their share price increase to levels that are either too high or beyond the price levels of the similar companies in their sector.

The difference between primary and securities market The primary securities market refers to the market that issues new securities. The securities can be bought from the shareholders and it is market that has capitals that are traded over a longer period of time. They are used on the exchange basis by the underwriters who set up the initial price range for a particular share and then they supervise the selling of the share. They are issued to the public in form of right issue, initial public offer and the preferential issue method. The secondary markets are the markets that are used to sell and buy the securities that have already been issued in an initial private or public offering. The market usually occurs after the new issue that is referred to as the aftermarket. The securities can be sold by and transferred from one investor or speculator to another.

Short sale and an example to show a calculation of gain or loss on it. The short sale refers to the selling of an asset to a seller who doesn’t own the asset at the time of the sale in the hope of purchasing the asset at a profit and at a lower price in the future. Example of short sale The bid and ask prices are as follows: Feb 25 Bid = 35. 22 ASK=35. 37 Aug 25 Bid= 39. 65 ASK = 39. 80 Jane enters into short sale on Feb 25 for 100 shares he then covers short position on Aug 25. The broker’s commission is $10 per transaction.

Her deposit haircut that is equal to 50% of proceeds received on sale of stock. The market rate of interest is the nominal rate of 8% that is compounded semi annually. The dividend on stock is $0. 40 per share that is payable on March 31 and $0. 50 per share payable on June 30. The Jane profit or loss on this short sale is solution Jane had an inflow of 2/25 of 1000×35. 22-10=3512 and outflow of 8/25 of 100×39. 8 + 10 = 3990. The short sale loss is (3990-3512) = $478 The difference between the interest at the market rate and the short rebate as the additional cost to Jane Sine he could have invested the hair cut at the market rate.

The amount of the haircut is 50% of the proceeds of the sale 50%x3512 = 1756 Jane’s loss of interest = (4% – 2. 5%) (1756) = 26. 34 The effective rates used are for the ? year period Feb to Aug. Jane’s Loss = 476+26. 34 =90 = $594. 34 5. IBM stock is today sold at $108 per share. One month ago stock was selling for $102 and put a limit order to buy one share for $100. During the month the stock price dropped to $96 then jumped to $111 before falling back to $108 the rate of return of the transaction. 6). The efficient frontier. It is a line that is created from the risk-reward graph that consists of the optimal portfolios.

The expected relationship between risk and return. Risk refers to the profitability that a hazard will turn out into a disaster, while return refers to money that one expects to derive from an investment.

The way risk is measured for stock The stock’s risk is measured by the degree to which the asset price moves in tandem with consumption. The riskier assets have a higher covariance with consumption and thus they have higher returns so as to compensate the investors for their additional risk that they incur as a result of investing in certain investment.

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