The terms "expected return," "required return," and "realized return" are important concepts in finance and investment analysis. They refer to different ways of assessing the performance of an investment. Here’s a breakdown of each:
1. Expected Return
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Definition: This is the return that an investor anticipates earning from an investment over a certain period. It is often based on the investment’s historical performance or an estimation of future outcomes.
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Calculation: Expected return can be calculated using the probabilities of different outcomes and their corresponding returns, often represented as:
\[ \text{Expected Return} = \sum (Probability \times Return) \]
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Use: It helps investors make decisions based on potential performance and compares different investments.
2. Required Return
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Definition: The required return is the minimum return that an investor expects to receive for taking on the risk of the investment. It compensates for the level of risk associated with the investment and often considers alternative investments (such as risk-free assets).
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Considerations: The required return can be influenced by factors such as the risk-free rate, the risk premium, and the market conditions, and it is often calculated using models like the Capital Asset Pricing Model (CAPM).
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Formula (CAPM):
\[ \text{Required Return} = \text{Risk-Free Rate} + \beta \times (\text{Market Return} - \text{Risk-Free Rate}) \]
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Use: Investors use the required return to evaluate whether an investment meets their risk-return profile. If the expected return meets or exceeds the required return, the investment is considered viable.
3. Realized Return
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Definition: The realized return is the actual return that an investor receives from an investment over a specific period. This is the return that can be observed or calculated based on actual performance and cash flows, including dividends, interest, and capital gains.
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Calculation: It can be calculated by taking the ending value of the investment and subtracting the initial value, divided by the initial value:
\[ \text{Realized Return} = \frac{(\text{Ending Value} - \text{Initial Value}) + \text{Income}}{\text{Initial Value}} \]
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Use: The realized return provides a measure of performance that can be compared against the expected and required returns to assess how well the investment has performed.
Summary
- Expected Return: The anticipated average return based on probabilities and historical data.
- Required Return: The minimum acceptable return that compensates for risk taken.
- Realized Return: The actual return received from an investment, reflecting its true performance.
Understanding these differences can help investors make informed decisions, evaluating whether an investment aligns with their financial goals and risk tolerance.