What is the required rate of return typically based on?

The required rate of return is primarily influenced by the risk associated with the asset in question, as well as prevailing market interest rates. Investors expect to be compensated for the level of risk they undertake when investing in an asset. Higher risk typically demands a higher required rate of return to account for the potential for loss or volatility, while lower-risk assets necessitate a lower return.

Current market interest rates also play a crucial role, as they provide a baseline for what investors can expect to earn from risk-free investments, such as government bonds. When market interest rates rise, the required rate of return for risky assets generally increases as well, reflecting the opportunity cost of investing in these assets versus safer alternatives.

By considering both the risk of the asset and current market rates, investors can establish a benchmark for the minimum return they require to justify taking on the investment risk. This approach ensures that the required rate of return aligns with the conditions and expectations of the broader financial environment.