Rate of Return Basics

CFA Level 1 - Portfolio Management

The Required Rate of Return
The required rate of return is the nominal rate of return that an investor needs in order to make an investment worthwhile.

This return varies over time and is comprised of the following:

• Real risk-free rate
• Inflation premium
• Risk premium.

Real risk-free rate of return
The real risk-free rate of return (R_f) is the minimum return an investor requires. This rate does not take into account expected inflation and the capital market environment.

Formula 17.1 Real risk free rate (Rf)  = (1 + nominal risk-free rate)     - 1            (1 + inflation rate)

Example: Real risk-free rate of return

Determine the real risk-free rate if the nominal risk-free rate is 8% and the inflation rate is 3%.

Answer:

Rf = (1 + 0.08) - 1 = 4.85%
        (1 + 0.03)

Nominal risk-free rate of return (R_nominal)
This is simply the real risk-free rate of return adjusted for inflation.

Formula 17.2 Nominal risk-free rate  = (1 + risk-free rate) x (1 + rate of inflation) - 1

Example: Nominal risk-free rate of return

Determine the nominal risk-free rate of return if the risk-free rate is 3% and the rate of inflation is 3%.

Answer:

R_nominal = (1 + 0.03) x (1 + 0.03) - 1 = 6.09%

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