Question

What is market return? How does it affect a firm?

What is Risk free rate? How does it affect a firm?

Answer 1

MARKET RETURN

The market return is an important concept in risk management because it is used to determine the market risk premium.

The market return, in turn, is part of the capital asset pricing model (CAPM) formula. This formula is used by investors, brokers, and financial managers to estimate the reasonable expected rate of return of an investment given the risks of the investment and cost of capital.

RISK FREE RATE OF RETURN

The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. The real risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.

BOTH THE RATE OF RETURN ARE USED IN CAPM MODEL WHERE IT AFFECTS THE FIRM MOST

CAPM is calculated according to the following formula:

Where:

Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market

The CAPM formula is used for calculating the expected returns of an asset. It is based on the idea of systematic risk (otherwise known as non-diversifiable risk) that investors need to be compensated for in the form of a risk premium. A risk premium is a rate of return greater than the risk-free rate. When investing, investors desire a higher risk premium when taking on more risky investments.