The risk premium is the excess return above the risk-free rate that investors require as compensation for the higher uncertainty associated with risky assets. The five main risks that comprise the risk premium are business risk, financial risk, liquidity risk, exchange-rate risk, and country-specific risk. These five risk factors all have the potential to harm returns and, therefore, require that investors are adequately compensated for taking them on.
- The risk premium is the extra return above the risk-free rate investors receive as compensation for investing in risky assets.
- The risk premium is comprised of five main risks: business risk, financial risk, liquidity risk, exchange-rate risk, and country-specific risk.
- Business risk refers to the uncertainty of a company's future cash flows, while financial risk refers to a company's ability to manage the financing of its operations.
- Liquidity risk refers to the uncertainty related to an investor's ability to exit an investment, both in terms of timeliness and cost.
- Exchange-rate risk is the risk investors face when making an investment denominated in a currency other than their own domestic currency, while country-specific risk refers to the political and economic uncertainty of the foreign country in which an investment is made.
Business risk is the risk associated with the uncertainty of a company's future cash flows, which are affected by the operations of the company and the environment in which it operates. It is the variation in cash flow from one period to another that causes greater uncertainty and leads to the need for a greater risk premium for investors. For example, companies that have a long history of stable cash flow require less compensation for business risk than companies whose cash flows vary from one quarter to the next, such as technology companies. The more volatile a company's cash flow, the more it must compensate investors.
Financial risk is the risk associated with a company's ability to manage the financing of its operations. Essentially, financial risk is the company's ability to pay its debt obligations. The more obligations a company has, the greater the financial risk and the more compensation is needed for investors. Companies that are financed with equity face no financial risk because they have no debt and, therefore, no debt obligations. Companies take on debt to increase their financial leverage; using outside money to finance operations is attractive because of its low cost.
The greater the financial leverage, the greater the chance that the company will be unable to pay off its debts, leading to financial harm for investors. The higher the financial leverage, the more compensation is required for investors in the company.
Liquidity risk is the risk associated with the uncertainty of exiting an investment, both in terms of timeliness and cost. The ability to exit an investment quickly and with minimal cost greatly depends on the type of security being held. For example, it is very easy to sell off a blue-chip stock because millions of shares are traded each day and there is a minimal bid-ask spread. On the other hand, small cap stocks tend to trade only in the thousands of shares and have bid-ask spreads that can be as high as 2%. The greater the time it takes to exit a position or the higher the cost of selling out of the position, the more risk premium investors will require.
Exchange-rate risk is the risk associated with investments denominated in a currency other than the domestic currency of the investor. For example, an American holding an investment denominated in Canadian dollars is subject to exchange-rate, or foreign-exchange, risk. The greater the historical amount of variation between the two currencies, the greater the amount of compensation will be required by investors. Investments between currencies that are pegged to one another have little to no exchange-rate risk, while currencies that tend to fluctuate a lot require more compensation.
Country-specific risk is the risk associated with the political and economic uncertainty of the foreign country in which an investment is made. These risks can include major policy changes, overthrown governments, economic collapses, and war. Countries such as the United States and Canada are seen as having very low country-specific risk because of their relatively stable nature. Other countries, such as Russia, are thought to pose a greater risk to investors. The higher the country-specific risk, the greater the risk premium investors will require.