Final answer:
The expected rate of return and the required rate of return determine the fair market price and the current market price of a security.
Step-by-step explanation:
In financial markets, the expected rate of return and the required rate of return are used to determine the fair market price and the current market price of a security. The expected rate of return is the return that investors anticipate receiving from an investment based on factors such as economic conditions, industry performance, and company-specific information. On the other hand, the required rate of return is the minimum rate of return that investors demand in order to invest in a security.
The relation between the expected rate of return and the required rate of return determines whether a security is overvalued, undervalued, or fairly priced in the market. If the expected rate of return is higher than the required rate of return, then the security is considered undervalued and its current market price may be lower than its fair market price. Conversely, if the expected rate of return is lower than the required rate of return, then the security is considered overvalued and its current market price may be higher than its fair market price.
For example, let's say the expected rate of return for a stock is 10%, but investors require a minimum rate of return of 12% to invest in the stock. In this case, the stock would be considered overvalued and its current market price would likely be higher than its fair market price.