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.
Key Insights
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
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 payits 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
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 ablue-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
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
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.
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
exchange-rate risk
Exchange rate risk refers to the risk that a company's operations and profitability may be affected by changes in the exchange rates between currencies. Companies are exposed to three types of risk caused by currency volatility: transaction exposure, translation exposure, and economic or operating exposure.
Four of the risk factors– market, size, value and momentum – are related to stocks and are grounded in the work of Fama and French [FAM 92] and Carhart [CAR 97]. The remaining two risk factors – credit and term – are related to bonds and are based on the work of Fama and French [FAM 93].
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.
The policy premium component comprises pure premium, operating expenses, investment and earning margin. Description: The premium is paid by the insured and the life cover is provided by the insurance company. Under insurance the risk is transferred from one party to the other after paying the premium.
It is the percentage return you get over what you'd receive if you made an investment with zero risk. So, for example, if the S&P has a risk premium of 5%, it means you should expect to get 5% more from investing in this index than from investing in, say, a guaranteed certificate of deposit.
The first component is the time value of money that is given by the risk-free rate of return and the second is the compensation for the risk investors take that is represented by the risk premium.
The market risk premium is a way to calculate the rate of return on a risky investment. To get this number, investors take the difference between the expected return and the risk-free rate.
The beta coefficient is a measure of a stock's volatility—or risk—versus that of the market. The market's volatility is conventionally set to 1, so if a = m, then βa = βm = 1. Rm - Rf is known as the market premium and Ra - Rf is the risk premium. If a is an equity investment, then Ra - Rf is the equity risk premium.
There are at least five crucial components that must be considered when creating a risk management framework. They are risk identification; risk measurement and assessment; risk mitigation; risk reporting and monitoring; and risk governance.
There are three important elements in the computation of premium. They are (1) mortality, (2) expenses of management, (3) expected yield on its investment.
Level Premiums in insurance terms mean fixed, uniform payments made by the policyholder at regular intervals (monthly or annually) to maintain the policy's active status. Key points to consider: Consistency: The amount paid doesn't change over time.
Introduction: My name is Horacio Brakus JD, I am a lively, splendid, jolly, vivacious, vast, cheerful, agreeable person who loves writing and wants to share my knowledge and understanding with you.
We notice you're using an ad blocker
Without advertising income, we can't keep making this site awesome for you.
