INVESTORS AND MARKETS : The required rate of return
This chapter has shown how to work out the cost of equity, i.e. the rate of return required on equity capital. The investor's required rate of return is not linked to total risk, but solely to market risk. Conversely, in a market in equilibrium, intrinsic – or diversifiable – risk is not remunerated.
The CAPM (Capital Asset Pricing Model) is used to determine the rate of return required by an investor.
Risk-free rate + β × market risk premium, or:
k = rF + β × (kM - rF)
Although the CAPM is used universally, it does have drawbacks that are either practical (for reliable determination of beta coefficients) or fundamental in nature (since it supposes that markets are in equilibrium). This criticism has led to the development of new models, such as the Arbitrage Pricing Theory (APT), and has highlighted the importance of the liquidity premium for groups with small free floats. Like the CAPM, the APT assumes that the required rate of return no longer depends on a single market rate; however, it considers a number of other variables too, such as the difference between government bonds and Treasury bills, unanticipated changes in the growth rate of the economy or the rate of inflation, etc.
Rates of return on bonds with different maturity dates can be plotted on a graph known as the yield curve. In order to avoid distortions linked to coupon rates of bonds, it is better to analyse zero-coupon curves that can be reconstituted on the basis of the yield curve.
The shape of the yield curve depends on changes in expectations about short-term rates and the liquidity premium that investors will require for making a long-term investment. In a risk-free environment, the long-term rate at n years is a geometric average of short-term rates anticipated for future periods. Generally, there is a positive link between the interest rate of a financial asset and its duration, which is where the rising yield curves come from. However, the yield curve can also slope the other way, especially during a recession.