A risk-free investment is defined as one where the investor is doubly sure of the amount and timing of the expected returns. Returns from most investments do not fit this pattern. An investor typically is not completely certain of the income to be received or when it will be received.
Investments can range in uncertainty from basically risk-free securities, such as treasury bills and bank term deposits, to highly speculative investments, such as the equity shares of small companies engaged in high-risk enterprises.
Most investors require higher rates of return on investments if they perceive that there is any uncertainty about the expected rate of return. This increase in the required rate of return over the risk-free rate is known as risk premium. Basically, the risk premium represents a composite of all uncertainty such as business risk, financial risk or leverage risk, liquidity risk, exchange rate risk and country or political risk.
Business risk: It is the uncertainty of income flows caused by the nature of a company’s business. The less certain the income flows of the company, the less certain are the income flows to the investor too. It is influenced by factors such as sales, input costs, competition, overall economic climate and government regulations in that segment of the industry. Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the basic nature of the business of the firm.
Finance risk: It is the uncertainty introduced by the method by which the company finances its assets. If a company uses only equity shares to finance its assets, it incurs only business risk. If a company borrows loans to finance its assets, it must pay fixed financing charges (in the form of interest to the bankers or lenders) before providing income to the equity shareholders; so, the uncertainty of returns to the equity investor increases.
This increase in uncertainty because of fixed-cost financing is called financial risk or financial leverage and causes an increase in the share’s risk premium.
Liquidity risk: It is the uncertainty that exists in the stock market for a share. When an investor acquires an investment, he or she expects the investment to mature (as in the case of bonds) or to be salable to someone else. In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investments.