INV2601
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,INV2601
Exam Pack
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Revision Pack
,Study unit 1 - The investment setting
- Explain the concept of required rate of return and discuss the components of an
investor’s required rate of return
What is the required rate of return?
The required rate of return is the minimum return an investor should accept from an investment
to compensate him for deferring consumption which means not consuming.
What are the three components of an investor’s required rate of return?
The three components of an investor's required rate of return of the following:
● The time value of money during the period of the Investment
● The expected rate of inflation during the period
● The risk involved
- Differentiate between the real risk-free rate of return and the nominal risk-free rate of
return and calculate both return measures
The time value for money here refers to the real risk-free rate of return which is the price
charged for the exchange between current goods(consumption) and future goods(consumption).
RRFR is the starting point to determine an investor's required rate of return. To determine the
required return the Investor has to determine the nominal risk-free rate of return and address
premiums to compensate for risks associated with the investment.
What are the two factors that influence the nominal risk-free rate?
They are namely the expected rate of inflation and the conditions in the capital market.
, What is the NRFR and RRFR equation?
NRFR = [(1 + RRFR)(1 + EI) - 1 * 100
(1 + N RF R)
RRFR = [ (1 + EI) − 1] * 100
- Explain the risk premium, the associated fundamental sources of risk, and why these
sources are complementary to systematic risk
What is a risk premium?
An increase in the required rate of return over the NRFR is known as a risk premium (RP). We
required RP is a composite of the following major sources of risk:
● Business risk
● Financial risk
● Liquidity risk
● Market risk
● Political risk
● Scalability risk
● Convertibility risk
Discuss business risk
Business risk refers to the extent of certainty or lack thereof about a firm's cash flows as a
result of the nature of its business. Companies of firms who are the sole proprietors are in a
monopoly and have a greater certainty about their income and cash flows. They require lower
risk premiums than cyclical firms.
Discuss financial risk
Financial risk refers to the financial leverage employed by a firm. The greater the extent to
which debt in relation to equity is used to finance the firm, the greater the financial leverage the
greater the financial risk. People are just worried if the Firm can pay its bills.
Discuss liquidity risk
Liquidity risk refers to the speed of a transaction which means time needed to convert an asset
to cash as well as the price at which an investment can be sold. Liquidity risk refers to the effort
and certainty of trading a specific investment instrument in the secondary financial markets. For
example liquid Investments are like government bonds which are easy to trade therefore they
charge a price or a liquidity premium in contrast to things like property.
Discuss market risk
Market risk refers to adverse moments in the value of equities currencies interest rates and
commodities. Currency risk for example refers to the probability of receiving a reduced amount
of a domestic currency when investing in a security that makes payments in a currency other
than the portfolio's legal tender.
Exam Pack
Questions +
Answers
Revision Pack
,INV2601
Exam Pack
Questions +
Answers
Revision Pack
,Study unit 1 - The investment setting
- Explain the concept of required rate of return and discuss the components of an
investor’s required rate of return
What is the required rate of return?
The required rate of return is the minimum return an investor should accept from an investment
to compensate him for deferring consumption which means not consuming.
What are the three components of an investor’s required rate of return?
The three components of an investor's required rate of return of the following:
● The time value of money during the period of the Investment
● The expected rate of inflation during the period
● The risk involved
- Differentiate between the real risk-free rate of return and the nominal risk-free rate of
return and calculate both return measures
The time value for money here refers to the real risk-free rate of return which is the price
charged for the exchange between current goods(consumption) and future goods(consumption).
RRFR is the starting point to determine an investor's required rate of return. To determine the
required return the Investor has to determine the nominal risk-free rate of return and address
premiums to compensate for risks associated with the investment.
What are the two factors that influence the nominal risk-free rate?
They are namely the expected rate of inflation and the conditions in the capital market.
, What is the NRFR and RRFR equation?
NRFR = [(1 + RRFR)(1 + EI) - 1 * 100
(1 + N RF R)
RRFR = [ (1 + EI) − 1] * 100
- Explain the risk premium, the associated fundamental sources of risk, and why these
sources are complementary to systematic risk
What is a risk premium?
An increase in the required rate of return over the NRFR is known as a risk premium (RP). We
required RP is a composite of the following major sources of risk:
● Business risk
● Financial risk
● Liquidity risk
● Market risk
● Political risk
● Scalability risk
● Convertibility risk
Discuss business risk
Business risk refers to the extent of certainty or lack thereof about a firm's cash flows as a
result of the nature of its business. Companies of firms who are the sole proprietors are in a
monopoly and have a greater certainty about their income and cash flows. They require lower
risk premiums than cyclical firms.
Discuss financial risk
Financial risk refers to the financial leverage employed by a firm. The greater the extent to
which debt in relation to equity is used to finance the firm, the greater the financial leverage the
greater the financial risk. People are just worried if the Firm can pay its bills.
Discuss liquidity risk
Liquidity risk refers to the speed of a transaction which means time needed to convert an asset
to cash as well as the price at which an investment can be sold. Liquidity risk refers to the effort
and certainty of trading a specific investment instrument in the secondary financial markets. For
example liquid Investments are like government bonds which are easy to trade therefore they
charge a price or a liquidity premium in contrast to things like property.
Discuss market risk
Market risk refers to adverse moments in the value of equities currencies interest rates and
commodities. Currency risk for example refers to the probability of receiving a reduced amount
of a domestic currency when investing in a security that makes payments in a currency other
than the portfolio's legal tender.
