E(Ri) = Rf + Bi(E(Rm) – Rf)
E(Ri): The expected rate of return calculated based on the following criteria
Rf: The risk free rate of return
Bi: Beta
E(Rm): Is the current market return on investment
In this calculation, we are trying to see if the investment being analyzed worthy based current risk and return. I first want to explain a few factors here before I dive into the issue.
The beta for an investment is based generally on a major index like the S&P 500. It is comparing the change of value for the investment to the change of the overall market. Without going into how to calculate, an investment that moves exactly with the market has a Beta of 1, the exact opposite -1, half the market .5, etc... So you get the picture.
In a similar fashion, the market rate is based on the rate of return for the market as a whole. In other words, what can we expect to earn if we just invest in the market altogether? Again, this is using a major index like the S&P 500.
So let's do the order of operations. The first part is the difference in market rate and the risk free rate. This just means, how much more do we earn in the market than we do risk free. This is known as the market premium.
The second part is multiplying the beta to the market premium. This says that with X amount of risk/sensitivity we can expect to earn X amount.
Then we add in back in the risk free rate. This gives us our total rate of return we have to make if we want to do perform at or better than the market for the risk the investment holds.
If that was confusing, and I'm sure it was. Here is a visual
E(Ri) = 1% + 1.5(10%-1%)
1 is the risk free rate
1.5 is the beta
10 is the market return
Therefore, the required rate of return is 14.5% (Risk goes up, so does our required rate of return)
If we lower the beta to .5, the new rate would be 5.5% (Risk goes down, so does our required rate of return)
Now to the point…
I waited to explain the risk free rate so I could make my point. The risk free rate is based on government bonds. These are considered risk free because of the high credit rating of the US government. This is why the returns are so low. (low risk, low return)
Junk bonds are that of companies with low credit ratings that could possibly default on the debt and not be able to pay you back. Since these companies need money they are willing to sell bonds at a high rate of return just to get someone to buy them. This is just like if you go to get a car loan and have poor credit. The bank may give you the loan, but the interest will be very high. These credit ratings range from this level all the way to where the US government stands. STOOD.
Because now you know how the risk reflects the return, it is only natural that the rate would increase on the "risk free rate" since the credit rating of the US government has been downgraded. Therefore, impacting our rate of return required for investments. Let's bump up the "risk free rate" on our calculation and see what happens.
E(Ri) = 2% + 1.5(10%-2%)
14% is the new required rate of return
By doubling the risk free rate we decreased the required rate of return by .5%
In conclusion, it's a good time to look at investing in businesses that are doing well.
