Required Rate of Return
Also written Required return · RRR
The minimum return an investor expects before committing money: the nominal risk-free rate plus a risk premium. It is not a guaranteed, forecast or realised return.
In plain language
Before putting money anywhere, every investor has a number in mind below which the investment is simply not worth it. That number is the required rate of return.
The workbook builds it in three layers. The investor wants to be paid for:
- Waiting — the pure time value of money, because consumption is being postponed.
- Inflation — because prices will rise while the money is tied up.
- Uncertainty — a risk premium, because the future payment may not arrive as promised.
Add the three and you have the required rate of return. The riskier the investment, the bigger the third layer, and the higher the hurdle it must clear.
How it works
Chapter 1, section 1.4, gives the building blocks in simple additive form:
- Nominal risk-free rate = Real risk-free rate + Inflation
- Required rate of return = Nominal risk-free rate + Risk premium
The workbook notes the additive version is a simplification "for smaller values". The exact version for the nominal rate is multiplicative: [(1 + real rate) × (1 + expected inflation)] − 1. With a 2% real rate and 6% expected inflation, that is 8.12%, not 8%.
The workbook is explicit about what the required return is not: it is not a guaranteed or assured return, it is different from expected or forecasted return, and it is different from realised return.
It is also the discount rate in valuation. In Chapter 4 the intrinsic value of a bond is the present value of its cash flows discounted at the investor's required rate of return. The decision rule: buy if intrinsic value exceeds market price — or, equivalently, buy if the bond's yield at market price exceeds the required return.
The formula
Required rate of return = Nominal risk-free rate + Risk premium
where Nominal risk-free rate = [(1 + Real risk-free rate) × (1 + Expected inflation)] − 1 (approximately real rate + inflation for small values).
A worked example
Building the number. Using Chapter 1's figures: real risk-free rate 2%, expected inflation 6%.
- Nominal risk-free rate = (1.02 × 1.06) − 1 = 8.12%
- Suppose Ramesh demands a risk premium of 5% for a corporate bond (this premium is illustrative).
- Required rate of return ≈ 8.12% + 5% = 13.12%
Using the number. Chapter 4's Illustration 4.2 gives a bond with a 12% coupon, five years to maturity, trading at ₹975 per ₹1,000 face value, with a YTM of 12.69%.
| Investor | Required return | YTM at ₹975 | Decision |
|---|---|---|---|
| Ramesh | 13.12% | 12.69% | YTM below requirement — do not buy |
| Suresh (already holds it) | 12% | 12.69% | YTM above requirement — hold |
Same bond, same price, opposite decisions. The bond has not changed; the investors' hurdles have.
Why NISM asks about it
Chapter 1 (Investments), section 1.4, "Estimating the required rate of return", is the source, and its first sample question is built on it: when future payment is uncertain, the extra return demanded over the nominal rate is the risk premium. Chapter 1's learning objectives list "concept of required rate of return" by name. The idea returns in Chapter 4 (bond valuation) as the discount rate and the buy/sell hurdle, and underlies the risk-return trade-off that Chapter 9's risk profiling and Chapter 10's risk-adjusted measures build on.
Common exam traps
- "Required return is the return the investment will deliver." No. It is the minimum the investor demands. The workbook separates it from expected and realised return.
- Required return is not guaranteed. An investor can require 13% and receive 4%.
- 8% versus 8.12%. The additive formula is an approximation. If the options include 8.12%, the question wants the exact method.
- The risk premium is the extra over the nominal risk-free rate, not over the real rate.
- In the Excel PRICE illustration, "Yield" means the required return, not the bond's YTM, and "Price" is intrinsic value, not market price. Chapter 4 warns about exactly this confusion.
- A workbook figure that does not reconcile. Chapter 4's Illustration 4.1 lists a 15% required yield and states an intrinsic value of ₹929.76 for a ₹1,000 bond; those inputs actually give about ₹897.04, and ₹929.76 corresponds to a 14% yield. Both figures are printed in Chapter 4.
Where this is taught
- Series XXI-B · Chapter 1: Investment Landscapeintroduced here
- Series XIX-C · Chapter 1: Investments Landscapeintroduced here
- Series XIX-E · Chapter 1: Investments Landscapeintroduced here
- Series XXI-A · Chapter 1: Investmentsintroduced here
- Series XIX-D · Chapter 1: Investments Landscapeintroduced here
Related terms
- Yield to MaturityThe single discount rate at which a bond's future coupons and redemption amount add up to exactly its market price today — the return you actually earn if you hold it to maturity.
- ReturnThe reward for postponing consumption — the difference between what an investor gives up today and the larger amount received later, measured in several ways depending on the purpose.
- Time value of moneyThe principle that the same sum of money is worth different amounts at different points on a timeline, because money held today can be invested and because inflation erodes what it will buy.
- Risk premiumThe extra return an investor demands over the nominal risk-free rate as compensation for uncertainty about future cash flows — the last and largest block in the required rate of return.
- Nominal Risk-free RateThe return on an investment whose amount and timing are certain, before adjusting for inflation: the real risk-free rate plus compensation for expected inflation.
- Real Risk-free RateThe basic return an investor demands purely for postponing consumption, assuming no inflation and no uncertainty about future cash flows — the pure time value of money.
- Political riskThe volatility of returns caused by the possibility of a major change in the political or economic environment of a country — the reason investors in unstable systems add a country risk premium.
- Ex-ante returnThe forward-looking expected rate of return: the sum of the possible returns multiplied by their probabilities. The opposite of ex-post return, which is computed from historical data.
- Opportunity CostThe benefit given up on the next-best alternative when money is committed to one investment instead of another — the yardstick an AIF return has to beat before it counts as a good return.
- Intrinsic value of a bondThe sum of the present values of all a bond's future cash flows, discounted at the investor's required rate of return. Buy if it exceeds the market price; sell if it is below.