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:
- Business risk
- Financial risk
- Liquidity risk
- Exchange rate risk
- Political risk.
These risks comprise systematic risk, and cannot be avoided through diversification since they affect the entire market.
- 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.
- 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.
- 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.
- 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.
- 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)
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