The Five Components of an Investors Required Rate of Return

In financial theory, the rate of return at which an investment trades is the sum of five different components. They are:

1. The Real Risk-Free Interest Rate

This is the rate to which all other investments are compared. It is the rate of return an investor can earn without any risk in a world with no inflation.

2. An Inflation Premium

This is the rate that is added to an investment to adjust it for the market’s expectation of future inflation. For example, the inflation premium required for a one year corporate bond might be a lot lower than a thirty year corporate bond by the same company because investors think that inflation will be low over the short-run, but pick up in the future as a result of the trade and budget deficits of years past.

3. A Liquidity Premium

Thinly traded investments such as stocks and bonds in a family controlled company require a liquidity premium. That is, investors are not going to pay the full value of the asset if there is a very real possibility that they will not be able to dump the stock or bond in a short period of time because buyers are scarce. This is expected to compensate them for that potential loss. The size of the liquidity premium is the dependent upon an investor’s perception of how active a particular market is.

4. Default Risk Premium

How likely do investors believe it is that a company will default on its obligation or go bankrupt? Often, when signs of trouble appear, a company’s shares or bonds will collapse as a result of investors demanding a default risk premium. If someone were able to acquire assets that were trading at a huge discount as a result of a default risk premium that was too large, they could make a great deal of money. Many professional money managers actually bought shares of Enron’s corporate debt during the now-famous meltdown of the energy-trading giant. In essence, they bought $1 of debt for only a few pennies. If they can get more than they paid in the event of a liquidation or reorganization, it can make them very, very rich.

K-Mart is a wonderful example. Prior to its bankruptcy, hedge fund manager Eddie Lampert and distressed debt expert Marty Whitman of Third Avenue Funds, bought an enormous portion of the retailer’s debt. When the company was reorganized in bankruptcy court, the debt holders were given equity in the new company. Lampert then used his new controlling block of K-Mart stock with its improved balance sheet to start investing in other assets.

3. Maturity Premium

The further in the future the maturity of a company’s bonds, the greater the price will fluctuate when interest rates change. That’s because of the maturity premium. Here’s a very simplified version to illustrate the concept: Imagine you own a $10,000 bond with a 7% yield when it is issued that will mature in 30 years. Each year, you will receive $700 in interest in the mail. Thirty years in the future, you will get your original $10,000 back. Now, if you were going to sell your bond the next day, you would likely get around the same amount (minus, perhaps, a liquidity premium as we already discussed.)

Consider if interest rates rise to 9%. No investor is going to accept your bond, which is yielding only 7%, when they could easily go to the open market and buy a new bond that yields 9%. So, they will only pay a lower price than your bond is worth – not the full $10,000 – so that the yield is 9% (say, maybe $7,775.) This is why bonds with longer maturities are subject to much greater risk of capital gains or losses. Had interests rates fallen, the bond holder would have been able to sell his or her position for much more – say rates fell to 5% then he could have sold for $14,000. Again, this is a very simplified version of how it would be done and there is actually a good deal of algebra involved but the results are roughly the same.

How These Five Components of an Investor’s Required Rate of Return Fit Together

Keep in mind no one is likely to sit around and say, “You know, I think I’ll only pay a liquidity premium of x%.” Instead, they often look at a stock, bond, mutual fund, car wash, hotel, patent, or other asset and compare it to the price at which it is trading on the market. At this point, the laws of supply and demand often kick in until equilibrium is reached.