Components of Investor's Required Rate of Return

d. explain the components of an investor’s required rate of return (i.e., the real riskfree rate, the expected rate of inflation, and a risk premium) and discuss the risk factors to be assessed in determining a country risk premium for use in estimating the required return for foreign securities;


Five risk components determine risk premiums

Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk


Equity risk premiums are to be derived for each country in which assets are to be acquire for a portfolio.

The five risk components differ substantially between countries:

Business risk varies across countries because it is a function of the variations in the economic activity within a country and also of the operating leverage used by firms within a country. For example, for many years the financing of companies in India was done on the basis of a long debt to equity ratio of 2:1. It is only recently that more conservative debt equity ratios became the norm.

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