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6.2 Sources of Risk

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Next we come to the sources of Risk. Here we will discuss about the major sources of risk and uncertainty. This includes:

  • Business risk- It is the uncertainty of income flows caused by the nature of a firm's business. The less certain the income flows of the firm, the less certain the income flows to the investor. Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the basic business of the firm. On the other hand if the flows are regular and certain then the investor will not demand a premium.
  • Financial Risk- It is the uncertainty related to how the company has financed its capital. If a firm uses only common stock to finance investments, it incurs only business risk and there is no financial risk. If a firm borrows money to finance investments, it must pay fixed financing charges despite the fact if there are any profits or not and that too prior to providing income to the common stockholders, so the uncertainty of returns to the equity investor increases. This presence of debt induces the shareholder to ask for a risk premium.
  • Liquidity risk- It is the uncertainty which is built in by the functioning of the secondary market for an investment in a particular country. The investor expects to be able to convert the security into cash easily and use the proceeds for current consumption or other investments. The more difficult it is to make this conversion, the greater the liquidity risk.
  • Exchange rate risk- It is the uncertainty of returns to an investor who acquires securities or invests in investments denominated in a currency different from his home currency. This risk is mainly associated with the exchange rates. The more volatile the exchange rate between two countries, the less certain would be the exchange rate, the greater the exchange rate risk, and the larger the exchange rate risk premium an investor will require.
  • Country risk- It is also called as political riskis the uncertainty of returns associated with a particular country. This is triggered by unexpected political or economic events in the country.

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