Required Rates of return is one of the key factors which influence an investment decision. Actually, Determinants of Required Rates of Return helps to calculate the required rates of return on an investment. Sometimes the required rates of return are considered as the cost of capital/expected rates of return which basically used as a discounting or compounding factor. By using this factor, we actually calculate the present and future value of cash flows.
Here, determining factors are getting more important because this help to find out what should be our minimum required rates of return on investment. But the question is what are the determinants of required rates of return?
Determinants of Required Rates of Return
There are three broad determinants of Required Rates of Return and these are as follows:
Time Value of Money
Expected Rate of Inflation for a particular economy
Involvement of Risk on Investment
Time Value of Money
The present value of money
Future value of money
Expected Rate of Inflation (Decline in Purchasing Power of Money)
Every economy may have inflation which is alright up to a considerable percent but exceeding inflation is not good for the economy. At the time of calculating expected rates of return, we must consider inflation. Higher the inflation, higher the required rates of return. It is a central bank and government responsibility to adopt an effective economic policy by which an accepted rate of inflation can be there for an economy. Investment selection process is influenced by the required rate of inflation.
Involvement of Risk with Investment
You know, there is nothing where risk is not involved. And it is money we talk about is more sensitive towards risk. Risk can vary from industry to industry, company to company, person to person. But the common thing is higher the risk higher the rates of return person expect from an investment. Although you may find there is a variation of risk-taking behavior among the individuals which is influenced by the personal trait of an individual. Risk can be broadly categorized into two head; one is systematic and other is an unsystematic risk.
Systematic Risk: Directly involved with the system which arises from the macroeconomic factors and it is not possible to minimize this type of risk through diversification of investment.
Unsystematic Risk: Unsystematic is a type of risk which is possible to minimize through diversification of investment. With this risk, there is a correlation between risk and diversification.
The determination process is involved with complicated work because the process is depending on how market change over time and how investors behave with it.
Market change because of the following reasons
A wide range of available investment alternatives
Return on specific assets change dramatically
Change in interest rate over the time period
It does not necessarily need to be the same required rates of return for all the people. The rate will vary according to the economic factors and the personal risk-taking behavior of an individual. So it will be better for you if you identify the influencing factors and then calculate your required rates of return on investment.
You may have a question in your mind that is it possible to minimize systematic risk? If you have then I am right here with your answer. After reading this hope you will understand what actually systematic risk is, what are the factors related with this and is there any way to minimize systematic risk or not.
First of all, let me explain the meaning of systematic risk. The risk associated with macroeconomic factors like; market interest rate, inflation, the rate of unemployment, economic recession, oil price etc. are the source of systematic risk. These factors cannot be changed or influenced by individual or organization. Normally risk which cannot be minimized through diversification of investment is considered as a systematic risk. In another sense risk which is beyond the control of individuals or organization is a systematic risk.
Minimizing risk is possible only through investing in negatively correlated financial securities. Here negatively correlated means the return of an individual security is not directly related to the return of other securities.
The main thing is, through diversification only we can minimize unsystematic risk portion which is arisen from the microeconomic factors. Because microeconomic factors can be controlled by individuals or organization through taking a proper economic decision. So at this point, we basically can say the unsystematic risk is a controllable and systematic risk is out of control, but the question is why systematic risk is out of control?
The influencing factors of systematic risk come from macroeconomic sources which are beyond our control. As individuals we do not have control over the unemployment rate of our country, we cannot reduce or control the inflation rate, we cannot fix the oil price, we cannot change the market interest rate, we cannot improve our unexpected economic recession situation by our own. Only proper economic policy taken by government can influence/ change or control these factors. That’s why as an individual’s we cannot minimize systematic risk.
It is not necessary that the percent of systematic risk always remain fixed. It can vary according to the change of economic condition. When there is a recession, more systematic risk will be there. For economic boom situation, the market provides more income, ensure less unemployment. And for these, there will have a less systematic risk.
Beta is the measures of Systematic Risk, which is the function of macroeconomic factors. We can calculate systematic risk by:
Systematic Risk (Beta) = Covariance between Individual Securities & Market/ Variance of Market
You know that a market beta (Systematic Risk) is always 1. If your investment (Securities) beta is less than 1 then your investment is more stable (less systematic risk) than the market. On the other hand if your investment (Securities) beta is more than 1 then your investment will more unstable (more systematic risk) compared with the market.
At the end of these brief explanation, we can say that it is not possible to minimize the systematic risk. So it would be wise decision to work for minimizing unsystematic risk through diversifying your investment and try to make an optimal portfolio.
If you like this article then please leave your comment, or if you have any confusion about this topic then let me know.
Difference between Systematic and Unsystematic Risk
As an investor, you must know the difference between systematic and unsystematic risk because it will help you to take an effective investment decision. If you observer the investment decision of an investor, you can see that their investment decision is highly influenced by their risk-taking behavior. Although future is uncertain, people always try to assume how much risk may arise in future if an investment is made.
A risk is the portion of uncertainty which we can measure. Normally risk is considered the deviation between what an investor expects and in return what he/she gets.
In a broader sense risk can be categorized into two types; one is a systematic risk which is a non-diversifiable risk and other is an unsystematic risk or non-systematic risk or diversifiable risk. Let have a detail discussion of systematic risk and unsystematic risk with examples:
The percent of risk which we cannot minimize or reduce through diversification is considered as a systematic risk. This means that this type of risk is impossible to eliminate by an individual. It is directly related to the market, that’s why systematic risk also is known as market risk. From my point of view, the systematic risk arises from the macroeconomic factors (inflation, unemployment rate, oil price etc.) which are beyond our control. Only through the proper economic planning of government can reduce this types of risk. One important thing you need to know that although implementation of effective economic policies by the government would reduce this type of risk it needs time to be visible in the market. That’s why we cannot consider it when taking our individual investment decisions.
Beta is the measure of systematic risk and market beta is always one. The reason behind market beta is to be 1 is that we cannot minimize or eliminate systematic risk by our own. Beta can be calculated by dividing the covariance between individual securities and market to the variance of the market.
Beta = Systematic Risk
Examples of Systematic Risk
As we have already know that systematic risk arises because of change in macroeconomic factors, for showing the example of systematic risk we will use macroeconomic factors (Inflation rate, unemployment rate, market interest, oil price and political condition).
Suppose market interest rate is increased, in this case, if we want to borrow money from the market we have to pay more interest than previous because the cost of funds increased. Individually we cannot change the market interest rate so this works as a systematic risk.
Increase in the inflation rate, this means the buying power of money is decreased. For this reason, we can buy less resource than previous. So increase in inflation works as a systematic risk which existed in the market. The only monetary policy of government can influence the inflation rate.
If there is an increase in unemployment rate then people will have less money to purchase goods and services. And this will create a negative impact on the business which is beyond the control of individuals.
Unsystematic risk is also known as diversifiable risk or nonsystematic risk. This type of risk arises from the micro-economic factors which directly or indirectly related with business and through carefully managed you can eliminate this unsystematic risk.
A popular portfolio management concept is diversification, through investing in negatively correlated investment alternatives. That is investing in different companies from different industries which do not have any direct link between them. The better you manage your portfolio the lower will be your systematic risk.
As unsystematic risk is not directly related with the economic system, we can manage it in a better way through taking effective decision individually and maximize our return on investment.
Examples of Unsystematic Risk
Individual industry or company related any kinds of risk is considered as unsystematic risk for the company. Examples of unsystematic risk can be:
Increased labor turnover rate due to dispute of payment related issues among employer and employee.
Increase in research and development cost of the company.
Increase in operational expenses.
Here in this graph, you can see that systematic risk is fixed in nature, that’s why we work on with unsystematic risk to eliminate it or keep it at a lower level. If it is possible then the total risk of the investment will be reduced.
From the above clarification about systematic and unsystematic risk, we can easily identify much difference between systematic risk and unsystematic risk of the business/investment. Here is the list of difference between systematic and unsystematic risk:
Systematic risk arises on account of the economy with uncertainties and the tendency of individual securities to move together with the change in the market.
Unsystematic risk is that part of risk which arises from the uncertainties and which are unique to individual securities and can be diversifiable.
Directly related to the economic system of a country.
Directly not related to the economic system, rather it is more about business or company related.
Systematic risk is known as non-diversifiable risk/ not diversifiable/ market risk/ macroeconomic risk.
Unsystematic risk is known as diversifiable risk, not a systematic risk.
We cannot reduce this type of risk individually
This type of risk can be reduced
Negatively correlated investment cannot eliminate the risk.
It is possible to eliminate the risk by forming a portfolio of negatively correlated investment.
Beta is a measure of systematic risk.
Unsystematic risk is the function of may macroeconomic factors related to business.
Basically, investors not try to work with systematic risk.
Investors always try to reduce this type of risk through better managing their investment.
Change in market interest rate
Increase in inflation
Change in oil price
Increase in business operational cost
Workers strike in the factory
Although we cannot work with the systematic risk we have many things to do with unsystematic risk because if we can manage it in a better way, then our business will be more profitable with lower risk. By choosing negatively related investment alternatives we can form an optimal portfolio but it is not an easy task for the financial manager. There is involvement of risk with every investment alternatives but we have to consider the systematic portion and then work with controllable factors which we actually can improve.
Finally, my suggestion is for you that take a time for risk analysis before any investment, otherwise, you may have to incur a loss. Risk always was there and will be there, so do not afraid to take the challenge, think and then take a right choice.
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