Investment Formula #1 Flashcards
(28 cards)
What is this formula
ri = rf + (rm - rf)B
Required or Expected rate of return (Security Market Line or SML)
What does “ri” represent?
Investors required or expected return
What does “rf” represent?
Risk free rate (could be given as three month t-bill rate)
What does “rm” represent?
Return of the market
What does “Bi” represent?
The beta (or risk) of stock “i”
What does “(rm-rf)” represent?
The market premium
What does “(rm-rf)Bi” represent?
The stock premium
What do you use this formula for?
Use this formula when the question asked to solve for the investors required rate of return
How do you put in the percentages for RRR? Whole numbers or decimal?
Whole numbers 9% should be entered as “9”
How will the formula sometimes be used on the exam?
You may need to solve for “r” in order to plug into the DDM formula.
What does beta represent?
Systematic risk
What is another name for required rate of return formula?
SML (Secure Market Line)
What is the purpose of this formula?
To compare market based risk adjusted returns or “what return should I require for the risk I am taking in this market?”
How will the exam Try to trip you up?
They will give you the market premium OR the stock premium. Be aware!
What the hell is “market premium”?
it generally refers to an amount paid above a certain value or a return above a risk-free rate (t-bills)
What is “ stock premium“?
In the stock market, a premium refers to a situation where a stock’s market price exceeds its face value or intrinsic value. This means investors are willing to pay more than the nominal worth of the share, typically due to strong fundamentals like consistent earnings or market dominance
Why does this formula start with rf?
Because the starting point is the “risk free rate of return”, which means that is your baseline for valuing any other investment. The starting point or launching point.
What is another way to phrase this formula conceptually?
The “risk free rate of return” (starting point) plus the “premium of the market” (amount you are willing to pay over the risk free return) times the beta (how much you are willing to risk over the rf). Boom!
Why is this formula important? What’s the point of its existence?
The required rate of return (RRR), also known as the is the minimum return an investor expects to receive for an investment, considering the associated risk. It serves as a benchmark to determine if an investment is worthwhile, meaning the RRR is the minimum acceptable return for taking on a specific level of risk. Aka: Is the juice worth the squeeze?
What is this formula often used with? What other formula?
The DDM
Why is it often used with the DDM?
To solve if a stock is worth buying and if it is priced fairly compared to it’ sell price
Would be why would someone need this formula?
Investors use the RRR to decide whether or not to pursue an investment. If an investment’s expected return is below the RRR, it’s generally considered less attractive
What does this formula represent?
It reflects the trade-off between risk and potential reward. A higher RRR suggests the investor is seeking a greater return to compensate for the perceived risks involved.
