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You are watching: Explain why the risk premium of a stock does not depend on its diversifiable risk.


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The danger premium is the excess rerotate over the risk-totally free rate that investors call for as compensation for the better uncertainty linked with risky assets. The 5 primary dangers that consist of the danger premium are organization risk, financial risk, liquidity risk, exchange-price threat, and country-particular threat. These five risk determinants all have actually the potential to harm returns and also, therefore, call for that investors are adequately compensated for taking them on.


The risk premium is the additional return over the risk-cost-free price investors receive as compensation for investing in risky assets.The threat premium is comprised of five major risks: organization hazard, financial threat, liquidity hazard, exchange-price hazard, and also country-certain risk.Business threat describes the uncertainty of a company's future cash flows, while financial danger describes a company's capability to manage the financing of its operations.Liquidity hazard describes the uncertainty concerned an investor's ability to departure an investment, both in terms of timeliness and also cost.Exchange-rate danger is the risk investors face as soon as making an investment denominated in a currency various other than their own domestic money, while country-specific danger refers to the political and economic uncertainty of the international country in which an investment is made.

Firm Risk

Business threat is the danger associated through the uncertainty of a company"s future cash flows, which are influenced by the operations of the firm and the setting in which it operates. It is the variation in cash flow from one duration to an additional that reasons better uncertainty and also leads to the need for a better hazard premium for investors. For example, carriers that have a long history of steady cash flow need less compensation for organization hazard than carriers whose cash flows vary from one quarter to the next, such as innovation service providers. The more volatile a company"s cash flow, the more it should compensate investors.


Financial Risk

Financial threat is the hazard connected via a company"s ability to manage the financing of its operations. Basically, financial risk is the company"s ability to payits debt duties. The more obligations a firm has, the greater the financial risk and the even more compensation is needed for investors. Companies that are financed with equity confront no financial hazard because they have no debt and, therefore, no debt responsibilities. Companies take on debt to rise their financial leverage; making use of external money to finance operations is attrenergetic bereason of its low cost.


The higher the financial leverage, the greater the possibility that the agency will be unable to pay off its debts, leading to financial injury for investors. The better the financial leverage, the more compensation is required for investors in the agency.


Liquidity Risk

Liquidity hazard is the threat linked through the uncertainty of exiting an investment, both in regards to timeliness and price. The capacity to departure an investment easily and with minimal expense significantly counts on the form of security being held. For instance, it is exceptionally straightforward to sell off ablue-chip stock because millions of shares are traded each day and also tbelow is a minimal bid-ask spread. On the various other hand, tiny cap stocks tfinish to profession just in the thousands of shares and also have bid-ask spreads that can be as high as 2%. The better the moment it takes to leave a place or the better the cost of offering out of the place, the even more threat premium investors will require.


Exchange-Rate Risk

Exchange-price danger is the danger linked via investments denominated in a currency other than the domestic money of the investor. For example, an Amerideserve to holding an investment denominated in Canadian dollars is topic to exchange-price, or foreign-exreadjust,risk. The better the historic amount of variation between the 2 currencies, the greater the amount of compensation will certainly be required by investors. Investments between currencies that are pegged to one an additional have actually bit to no exchange-price hazard, while currencies that tend to fluctuate a lot call for more compensation.


Country-Specific Risk

Country-certain risk is the hazard linked through the political and also financial uncertainty of the foreign nation in which an investment is made. These dangers can include significant plan changes, toppled governments, economic collapses, and also battle. Countries such as the United States and also Canada are seen as having actually exceptionally low country-certain threat bereason of their reasonably stable nature. Other countries, such as Russia, are thmust pose a higher danger to investors. The higher the country-specific hazard, the better the risk premium investors will need.

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