components of risk premium
What are the components of a risk premium?
The risk premium is the excess return above the risk-free rate that investors demand in compensation for the increased uncertainty associated with risky assets. The five main risks that make up the risk premium are business risk, financial risk, liquidity risk, currency risk and country-specific risk. All of these five risk factors can hurt returns and therefore require investors to be adequately compensated to hire them.
KEY INDICATIONS
The risk premium is the additional return over the risk-free rate that investors receive in compensation for investing in risky assets.
The risk premium comprises five main risks: commercial risk, financial risk, liquidity risk, foreign exchange risk and country-specific risk.
Business risk refers to the uncertainty of a company's future cash flows, while financial risk refers to the company's ability to manage the financing of its operations.
Liquidity risk refers to the uncertainty of an investor's ability to exit an investment, both in terms of opportunity and cost.
Currency risk is the risk investors face when making an investment denominated in a currency other than their home currency, while country-specific risk refers to the political and economic uncertainty of the foreign country in which an investment.
Business risk
Business risk is the risk associated with the uncertainty of a company’s future cash flows, which are affected by the company’s operations and the environment in which it operates. It is the variation in cash flows from period to period that causes greater uncertainty and leads to the need for a higher 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 flow varies from quarter to quarter, 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 pay its debts. The more bonds a company owns, the greater the financial risk and the more compensation investors need. Equity-backed companies bear no financial risk because they have no debt and, therefore, no debt obligations. Companies borrow to increase their leverage; using outside money to fund operations is attractive because of its low cost.
The greater the leverage, the greater the possibility that the company will not be able to repay its debts, with consequent financial damage for investors. The greater the leverage, the higher the required compensation for investors in the company.
Liquidity risk
Liquidity risk is the risk associated with the uncertainty associated with the exit from an investment, both in terms of opportunity and cost. The ability to exit an investment quickly and with minimal costs depends very much on the type of security held. It is very easy to sell a blue chip stock as millions of stocks are traded daily, and there is a minimum bid-ask spread. On the other hand, small-cap stocks tend to trade only thousands of shares and have bid-ask spreads that can be as low as 2%. The longer it takes to exit a position or the higher the cost of selling the position, the higher the risk premium demanded by investors.
Currency risk
Currency risk is the risk associated with investments denominated in a currency other than the investor’s national currency. For example, American detention of investment in Canadian dollars is subject to exchange or foreigners, the risk.
Country-Specific Risk
Country-specific risk is the risk associated with political and economic uncertainty in the foreign country in which an investment is made. These risks can include major political changes, overthrown governments, economic collapses and wars. Countries like the United States and Canada are believed to have very low country-specific risk due to their relatively stable nature. Other countries, such as Russia, are believed to pose a greater risk to investors. The higher the country-specific risk, the higher the risk premium demanded by investors.
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