Question

1. “An investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for the time the funds are committed, the expected rate of inflation, and the uncertainty of the future payments.”- Discuss

1. Risk Premium
2. The major sources of uncertainty.

Answer 1

i. In simple terms, risk premium is the excess returns that the investors expect over the risk free rate of return. Strictly defined, risk premium is the function of systematic risk with the aggregate market portfolio of risky assets for an individual asset. Investors expect risk premium for the extra risk borne by them when compared to a risk averse investor.

ii. The major sources of uncertainity are:

1. Business risk: It is related to the uncertainity of the income flows due to the firm's nature of business. The lesser the certainity of inflows, the investor receiving money from the business is also lesser. This increases the expected risk premium.

2. Financial risk: This uncertainity arises out of the method by which the firm finances itself. A highly leveraged firm i.e. a firm which has more debt, is more likely to increase the risk premium since the cash flow to equity investors will be lesser.

3. Liquidity risk : Liqudity is the feature of an asset wherein it can be re sold to someone else. The diffiicult it is resell the asset higher is the risk premium and vice versa.

4. Exchange rate risk : It is the uncertainity of returns to the investor when he acquires securities in currencies other than his home country. The risk is higher when investors buy and sell assets around the globe rather than domestic assets only.

5. Country risk: An uncertainity caused due to the political or economic environment of the country. The higher the political instability and a weak govrnment, the greater is the risk for an investor.