In an investment setting, an investor sets his required rate of return as the base return he requires from an investment. However, given the usual uncertainty in the market, it is difficult to meet that required rate of return exactly. As such, an investor would set his return above his required rate of return to diminish the risk that his required rate of return will not be met. The excess return above the investor's required rate of return is known as the risk premium.
The fundamental sources of risk that contribute to the need of the risk premium, such as:

  1. Business risk
  2. Financial risk
  3. Liquidity risk
  4. Exchange rate risk
  5. Political risk.


These risks comprise systematic risk, and cannot be avoided through diversification since they affect the entire market.

  1. Business Risk: Business risk is the risk that a business' cash flow will not meet its needs due to uncertainty in the company's business lines.
  2. Financial Risk: Financial risk is the risk to equity holders as a company increases its debt load. As debt load increases, interest expense also increases, leading to less income to be paid out to investors.
  3. Liquidity Risk: Liquidity risk is the uncertainty around the ability to sell an investment. The more liquid an investment is the easier it is to sell.
  4. Exchange-Rate Risk: Exchange-rate risk is the risk a company faces when it has businesses in other countries. When a company is in the business of producing or buying products in a country other than its own, a company can face exchange-rate risk when in the process when it needs to exchange currency to transact business as a part of its normal business routine.
  5. Political Risk: Political risk is the risk of changes in the political environment of a country in which company transacts its businesses. This risk could be caused by changes in laws relating to a specific business or even more serious as a country revolution that would cause disruption in a company's operations.


Learn how the expected extra return on stocks is measured and why academic studies usually estimate a low premium in the article Risk Premium.



The Security Market Line (SML)

Related Articles
  1. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  2. Insights

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  3. Managing Wealth

    Why Companies Need Risk Management

    Implementing risk management strategies can save an entire organization from failure. Is yours up to snuff?
  4. Financial Advisor

    Impact Investing Funds: What are the Risks?

    Impact investing funds can carry risks unique to this asset class, including political risk, currency risk and exit risk.
  5. Insights

    What is Liquidity Risk?

    Liquidity risk is the risk of being unable to sell an asset fast enough to avoid loss.
  6. Investing

    Understanding Market Risk Premium

    Market risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
  7. Investing

    10 Risks That Every Stock Faces

    As an investor, the best thing you can do is to know the risks before you buy in. Find out about 10 common stock risks you should look out for.
  8. Financial Advisor

    Active Risk vs. Residual Risk: Differences and Examples

    Active risk and residual risk are common risk measurements in portfolio management. This article discusses them, their calculations and their main differences.
  9. Investing

    Systematic Risk

    Systematic risk, also known as volatility, non-diversifiable risk or market risk, is the risk everyone assumes when investing in a market. Think of it as the overall, aggregate risk that comes ...
Frequently Asked Questions
  1. Can I fund a Traditional IRA, a 403(b) or a Roth IRA using pension money?

    Can pension money be used to fund other retirement accounts?
  2. What are unregistered securities or stocks?

    Before securities, like stocks, bonds and notes, can be offered for sale to the public, they first must be registered with ...
  3. How does a company move from an OTC market to a major exchange?

    The over-the-counter market is not an actual exchange like the NYSE or Nasdaq. Instead, it is a network of companies that ...
  4. Can I roll a traditional IRA into a 529 college account for my grandchild?

    The short answer: Not without paying taxes. But as with much of the tax code, there are various nuisances and exemptions ...
Trading Center