Economics » Financial Markets » How Households Supply Financial Capital

Expected Rate of Return, Risk, and Actual Rate of Return

The expected rate of return refers to how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability. It is usually the average return over a period of time, usually in years or even decades. Risk measures the uncertainty of that project’s profitability.

There are several types of risk, including default risk and interest rate risk. Default risk, as its name suggests, is the risk that the borrower fails to pay back the bond. Interest rate risk is the danger that you might buy a long term bond at a 6% interest rate right before market rates suddenly raise, so had you waited, you could have gotten a similar bond that paid 9%.

A high-risk investment is one for which a wide range of potential payoffs is reasonably probable. A low-risk investment will have actual returns that are fairly close to its expected rate of return year after year. A high-risk investment will have actual returns that are much higher than the expected rate of return in some months or years and much lower in other months or years. The actual rate of return refers to the total rate of return, including capital gains and interest paid on an investment at the end of a period of time.

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