What determines investors’ required rate of return from a bond or stock?
Investors’ required rate of return from a bond or stock (or any security) can be modelled using the Fisher equation of interest rates. In this formulation, any interest rate is a combination of a pure rate of return, an inflation premium, and a risk premium. The pure rate is independent of any particular security, however the inflation and risk premiums do depend on the investment in question. Investors determine an inflation premium based on their forecasts of inflation and the maturity of the investment how long the investment will be exposed to the inflation rate they forecast. They determine a risk premium based on their forecast of the variability of the investment’s returns and the correlation of those returns to the returns from the economy as a whole. Investors’ required rate of return then becomes the combination of the pure rate in the economy plus the specific inflation premium and risk premium appropriate for the security.
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