3 Factors That Influence the Rate of Return Essay

Any bondholder, or any investor for that matter, will allow three factors to influence his or her required rate of return. The three factors are the following: real (pure) rate of return, inflation, and risk premium. These three factors equal the risk free rate which is the rate of return of an investment with no risk of financial loss. This is also the rate that investors would expect from an absolutely risk-free investment over a period of time. Inflation is the constant and progressive increase in the prices of goods and services. If the total rate of return was below the actual economic interest rates then this would cause the lender (investor) to pay the borrower for use of his or her funds. So instead of creating mass chaos in our economic system, the inflation premium of interest rates results from lenders compensating for expected inflation by pushing interest rates higher. An example that can derive from taking the inflation premium into account is that when inflation is high, or expected to decline, look for long-term fixed rate bonds to â€Å"lock in† high market values. The real rate of return and the inflation premium determine the risk free rate of return. As an example, if the real rate of return were 2 percent and the inflation premium 3 percent, then we can say that the risk free rate of return is 5 percent. The real rate of return is described by our Corporate Finance book as the financial â€Å"rent† the investor charges for using his or her funds for one year. For example, if you make a $10,000 investment that earns 8% in one year, you would end the year with $10,800. So, you earn an extra $800, however, if inflation is at 3% for the year, your $10,800 is only worth $10,500. Your real rate of return is only 5%. Investors depending on dividends or interest from bonds are most affected by the costs of inflation. Stocks can be a little safer because companies can pass the higher cost of inflation to customers. Lastly, the risk premium is the premium associated with the special risks of a given investment. In other words, is the risk you take on an investment worth the reward? The risk relates to a firm’s inability to meet its debt obligations as they come due. For example, bonds possess a contractual obligation for the firm to pay interest to bondholders; they are considered less risky that common stock where no such obligation occurs. Treasury Bonds are backed by the â€Å"full faith and credit† of the U.S. government, whereas stocks are not. If you earn a risk free return from bonds at 3%, that becomes your baseline. Now, if any investment with risk must return more than 5%. The amount the investment returns over 3%is known as the risk premium. For example, if you are looking at a stock with an expected return of 12%, the risk premium is 9%.