MANAGEMENT is efficiency in climbing the ladder of success; LEADERSHIP determines whether the ladder is leaning against the right wall - Stephen Covey

Friday, November 11, 2005

Risk Premium & Investment!

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. All these five risk factors have the potential to harm returns and, therefore, require that investors are adequately compensated for taking them on.
Business Risk: This 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 theneed for greater compensation for investors.
Financial Risk: This is the risk associated with the uncertainty of a company's ability to manage the financing of its operations. Essentially, financial risk is the company's ability to pay of its debt obligations. The more obligations a company has, the greater the financial risk and the more compensation is needed for investors.
Liquidity Risk: This 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.
Exchange-Rate Risk: This is the risk associated with investments denominated in a currency other than the domestic currency of the investor. Exchange rate fluctuations cause these risks.
Country Specific Risk: This 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, war & not to forget potential for terrorist attacks!
How many of us actually consider any/all of the above risk factors prior to investing?


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