CFA Level 1 – Quantitative Methods, Required Rate of Return.
The Required Rate of Return is the return that is required by an investor based on the risk of the investment. It has three main components:
- Risk Free Rate (RFR)
- Expected Inflation Rate Premium (IP)
- Risk Premium
Given these components:
Required Rate of Return = (1 + RFR)(1 + IP) – 1
The basic theory is that the starting point for a investor’s return is the amount they can earn on a risk free asset (usually a AA rated government bond yield), plus the inflation expectation and finally (and most importantly) the perceived risk of the investment.