Question

1. What is the difference between the expected rate of return and the required rate of return?

What does it mean if they are different for a particular asset at a particular point in time?

Answer 1

Answer to the given question is as below:

Expected rate of return :

Expected rate of return is a percentage return which is expected to be earned by the investor on his investment.

In portfolio analysis, expected rate of return can be calculated either as a weighted average rate of return of all possible outcomes or using historical data.

Let's understand it through an example:

Example 1 (using probability distribution)

Suppose an investor has invested in Asset A. The percentage rate of return on Asset A has following 4 outcomes.

Probability	0.5	0.3	0.2
Rate of return	8%	10%	20%

Expected return on Asset A = weighted average =0.5*8+0.3*10+0.2*20 = 11%

The return expected to be earned on investment of Asset A is 11%.

Example 2 (using historical data)

An investor is planning to invest in security B. The historical percentage return of last 4 years of this security is given below:

Years	1	2	3	4
Rate of return	10	8	7.5	6.5

Now the expected return on security B is given by:

(10 + 8 + 7.5 + 6.5)/4 = 8%

Required rate of return :

In simple words, It is a minimum acceptable rate of return required by the investor on his investment.

In capital budgeting decisions, it is generally used as discount rate of to calculate present value of cashflows.

In general rule if investment's return is less than required rate of return then project should be rejected and vice versa.

Let's look at the example:

Suppose an investor is earning 6% annual interest rate on his savings account and he is planning to invest in a risk free treasury bond. In this case the treasury bond must yield more than 6% per year for the investor to consider taking his money out of the savings account and investing it in bond. Hence here the required rate of investor would be 6% on bond.

Expected rate of return and required rate of return may be different for a particular asset at a particular point of time.

If expected return is more than the required rate of return than it is worth buying the asset.

If expected return is less than the required rate of return then investment in project is not viable.