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 PremiumThe 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