Question

what is required rate of return (RRR) ?

Why RRR is important for the investor ?

as an investor , would you expect the required rate of return for investing in usa common stocks to be the same as the required rate of return on japaneese common stocks ?

what factors would determine the required rate of return for stocks ?

Answer 1

Answer1: The required rate of return is the minimum return expected by an investor on an investment done. It is the minimum return expected for the investment and the risk associated with the investments made. It takes into account the investment goals along with the risk factors and inflation.  

It is the required rate of return which determines if an investment is feasible or not. If the actual return on investment is less than required return, then such investments should be avoided.

There are various ways of calculating required rate of return. But the most common way of calculating it is as follows :

Formula for calculating required rate of return (RRR)=

rf + B rm -rf)

where rf = risk-free rate , $\beta$ = beta coefficient of an investment , rm= return of market

Answer2: AS stated above, it is the minimum return for an investment done. So this return differentiates between feasible and non-feasible investment.

If RRR is less than actual return , then the investment should be rejected and vice versa.

It determines and helps in the decision making of investment opportunities.

Answer3:

US and Japan are two different economies with different risk free rates and market setup. Both markets will not be correlated with each other in terms of returns as they are different economies with different economic growth, fiscal and monetary policy, inflation and so on. US dollar and Japanese Yen have a floating exchange rate which adds to the currency risk. The bond market of US is considered as a zero default risk market in the world. So the combination of each country's domestic return and currency risk will give a different required rate of return for both economies.

Answer4:

Factors that determine the required rate of return for stocks are as follows:

Risk of investments (trade off between risk and return):

High risks give high returns. Higher the risk, higher the volatility ( high beta stocks) and higher the returns. The rate of return of such stocks are higher than low risk investment assets like bonds or defensive stocks. But when a market suffers from slowdown then these stocks suffer the most.

Inflation: Inflation rates are an integral part of this calculation. So a high expected inflation rate, will mean high required rate of return. During high inflation period, inflation hurts the demand of an economy thus hurting the sales and profit earnings of companies which will drag the earnings from stock.

Economy: When an economy grows, more people get employed which means increase in consumption and consumer spending. The companies also post good revenue and profit numbers.Such factors will make the stock market move up thus making the return from stock market higher. But the bond prices will come down and give lower returns from bond market. ( stock market and bond market are inverse to each other)

Political Factors:

Political stability, ruling party, government policies and govt efforts in economic growth play a very critical role in growth of stock market. Political stability increases the business confidence and attract more institutional and direct investments. Political stability provide more visibility on future plans of government and eliminate the risk any sudden change of policies. All such factors give confidence to investors and increases the return on investments.

Hope you find it useful.