How to Calculate Equilibrium Rate of Return

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Equilibrium Rate of Return Calculator

The return on an investment with zero risk, like a government bond.
The measure of an asset's volatility in relation to the overall market.
The average return expected from the stock market as a whole.

Estimated Equilibrium Rate of Return:

function calculateERR() { var rf = parseFloat(document.getElementById('riskFreeRate').value); var beta = parseFloat(document.getElementById('assetBeta').value); var rm = parseFloat(document.getElementById('marketReturn').value); var resultDiv = document.getElementById('errResult'); var valueDiv = document.getElementById('errValue'); var formulaDiv = document.getElementById('errFormula'); if (isNaN(rf) || isNaN(beta) || isNaN(rm)) { alert("Please enter valid numerical values for all fields."); return; } // CAPM Formula: Er = Rf + Beta * (Rm – Rf) var equilibriumReturn = rf + (beta * (rm – rf)); valueDiv.innerText = equilibriumReturn.toFixed(2) + "%"; formulaDiv.innerText = "Calculated using CAPM: " + rf + "% + " + beta + " * (" + rm + "% – " + rf + "%)"; resultDiv.style.display = 'block'; }

Understanding the Equilibrium Rate of Return

The equilibrium rate of return is the expected return on an asset that compensates investors for its systematic risk. In a balanced market, this is the point where the demand for a security matches its supply. Finance professionals primarily use the Capital Asset Pricing Model (CAPM) to determine this theoretical value.

The CAPM Formula

To calculate the equilibrium rate of return, we use the following equation:

Re = Rf + β(Rm – Rf)

  • Re (Equilibrium Return): The return required by investors based on the asset's risk.
  • Rf (Risk-Free Rate): The return on "safe" investments, typically 10-year Treasury bonds.
  • β (Beta): A coefficient measuring how much the asset's price moves relative to the market. A beta of 1.0 means it moves with the market; >1.0 means it is more volatile.
  • Rm (Market Return): The expected return of a broad market index like the S&P 500.
  • (Rm – Rf): This is known as the Equity Risk Premium.

Step-by-Step Calculation Example

Imagine you are analyzing a technology stock and want to know its equilibrium rate of return. You gather the following data:

  1. Current Risk-Free Rate: 3.5%
  2. Stock Beta: 1.4 (indicating the stock is 40% more volatile than the market)
  3. Expected Market Return: 9.0%

Step 1: Calculate the Equity Risk Premium.
9.0% – 3.5% = 5.5%

Step 2: Multiply the Risk Premium by the Beta.
1.4 * 5.5% = 7.7%

Step 3: Add the Risk-Free Rate to find the total Equilibrium Return.
3.5% + 7.7% = 11.2%

Why This Metric Matters

The equilibrium rate of return is vital for determining if a stock is overvalued or undervalued. If the actual expected return of a stock (based on fundamental analysis) is higher than the equilibrium rate, the stock is considered undervalued (a "buy"). If the expected return is lower than the equilibrium rate, the stock is overvalued, as the potential reward does not justify the risk being taken.

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