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 comprised of five main risks: 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.
, 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 market risk premium is the difference between the expected return from an investment and the risk-free rate. The expected return and the risk-free rate, which comprise the market risk premium model's two main components, depend on the erratic market dynamics. It makes the model an expectation model.
H2: The risk premium is determined by the firm,s ability to repay and its default risk, the quality and length of the bank-firm relationship, the collateral/guarantees it is able to provide, the credit line size, the borrowing firm,s size, the owner-manager,s characteristics and the borrowing firm,s specific risk.
The risk premium formula is very simple: Simply subtract the expected return on a given asset from the risk-free rate, which is just the current interest rate paid on risk-free investments, like government bonds and Treasuries.
Typically, there are many factors which determine asset risk premium. The factors include business, exchange-rate, liquidity, and financial factors. Among these, the most significant factors are business and liquidity factors.
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.
An example of a risk premia strategy could be buying an alternatively-weighted index (for instance, one which assigns weightings by earnings rather than by size – as the benchmark does), and selling the benchmark index (often, but not always, the S&P 500 Index).
Equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular portfolio.
Clearly, the Good Security has a very high risk premium: 75% - 5%, or 70%. This might not seem too surprising, given the extreme risk involved. However, the Bad Security actually has a negative risk premium (i.e. a "risk discount"): -25% - 5% = -30%. Yet it too is very risky.
In CAPM the risk premium is measured as beta times the expected return on the market minus the risk-free rate. The risk premium of a security is a function of the risk premium on the market, Rm – Rf, and varies directly with the level of beta.
Market risk charges are components of the standard method ICS capital requirement. The standard method ICS market risk charges cover six risks: interest rate risk (IRR), equity risk, real estate risk, currency risk, non-default spread risk (NDSR) and asset concentration risk.
The CAPM model consists of two components: the risk-free rate and the market risk premium. The risk-free rate is the rate of return on a security with no risk, such as a government bond.
The market risk premium—measured as the slope of the security market line (SML)—is the difference between the expected return on a market portfolio and the risk-free rate.
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