Financial Risks: Risk Free Return and Risk Premium

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Almost all transactions that are carried out by business enterprises and companies are prone to some financial risk (Horcher 1). Financial risks general entail the possibility of incurring a loss or a certain degree of uncertainty on the expected return after making an investment. This therefore, means that the financial risks are diversified depending on the finance item they are attached to, in this case the asset classes. The assets of a company are normally grouped into classes in which, they are similarly governed and respond the same when it comes to market conditions. As such, the main classes of assets include stocks, money market instruments and the bonds or debt securities. Each of the aforementioned classes of assets is prone to different types of risks. This paper is therefore, an exploration of the main risks that are attributable to the different cases of assets, with an emphasis on the bond and shares.

Financial risk types

A risk free return is generally defined as the interest rate that is expected to be generated from an investment that was not associated to any kind of risk (Pietersz 1). An example is the Treasury bill of 3 months or rather the short-term treasury bonds. This is because it is normally a close approximation, hence free of any risk in virtual terms. On the other hand, a risk premium is the additional amount of risk on top of the risk-free rate of return, which investments re expected to generate. It can therefore, said that it is the additional compensation, which an investor gets for tolerating an extra risk on the investment. It also the amount that induces the investors to endure more risk on their investments. It is therefore true to conclude that investments that have a higher risk have a higher compensation.

The main risks relating to asset classes

A business enterprise or company is bound to incur different types of financial risks on the assets it deals with. However, these risks differ with the type of financial item involved. These risks include the following:

Credit Risk: This type of risk comes about in the event that the company or entrepreneur defaults in paying the principal amount or interest that is accorded to an investment (Harper 1). When this happens, the investor incurs losses on either the principal, interest by having a decrease in their cash flows as well as increased collection costs. This type of risk is of great concern when it comes to very large projects, which have large amounts of investment values. This is because, if such happens, the loss incurred will be paramount. The same case applies to investors of bonds who decide to hold them. However, different types of bonds will have different amounts of risks and returns. For instance, corporate bonds have a higher credit risk and returns compared to government bonds whose risk is minimal (Harper 1). As such, investment companies dealing with bonds referred to the low risk bonds as investment grade, while those with higher risk of default are referred to as junk bonds.

Foreign Exchange Risk: This is another type of risk associated with stocks and bonds. This type of risk comes about when an investor decides to invest in another country or uses the currency of another country in the computation of the investment. The main reason behind this is the fluctuating behavior of currency exchange rates in most markets. This risk applies to all financial items computed in a currency different from the domestic currency (Horcher 2). For instance, if one has invested in the Japanese stock market and the value of the stocks appreciates, there is a risk of incurring losses in the event that the Japanese yen weakens against the American dollar.

Country Risk: This risk is incurred in the event that a country is not in the position of honoring its financial commitments. This could be because of wars, droughts, floods, or serious cases of bankruptcy. When this happens, the investments of that country including; shares, bonds, futures, and mutual funds are significantly affected. This is because their performance in the global market is affected since the country has lost its trust among other countries of the globe. Country risk is in most cases experienced in countries with emerging markets or those that have significant deficits. When a country is experiencing this risk, investors tend to seize from investing such a country, something that further affects the investments already in the market of these countries. To overcome this problem, countries normally borrow finds from other stronger nations in terms of the economy, to do away with the deficit (McNeil, Frey, and Embrechts 2).

The three types of financial risks discussed above are those that are associated mainly associated with stocks and bonds. Otherwise, the list of financial risks incurred by companies and business enterprises is endless as almost each financial instrument or item has some degree of risk during investment. The other types of financial risks include, Liquidity risk, market risk, rate risk, counter party risk, operational risk, model risk, inflation risk, personal risk, and income risk just to mention a few (Horcher 2). The aforementioned risks will occur in different financial instruments/ items depending on other factors, as well.


From the above discussion, it is clear that financial risks are inevitable especially for investors. As such, investors are required to have sufficient knowledge of the type of risks associated with the type of investments they want to make (McNeil, Frey, and Embrechts 2). For instance, investors of stocks and bonds should be pretty aware of credit risks, country risks and foreign exchange risks before settling down to invest in them. This is because, the three are the main risks associated with stocks and bonds. With this information, investors are in a position to speculate the values of their investments in the market such that they can evade these risks in order to overcome the losses associated with them. Earlier in the paper, risk free return and risk premium were discussed. The two are associated with those investments that are free of any risks such as the short-term treasury bonds. Therefore, when an investment is not prone to any kind of risk, the investor is subject to risk free returns and premiums (Pietersz 1). Nevertheless, cases where investments are free of any risk are very rare and will in mots cases occur in markets under perfect economies. However, given the normal situation in the markets, risks are bound to be present and it only calls for the investor to be keen to avoid making huge losses on their investments.

Works Cited

Harper, David. Corporate Bonds: An Introduction to Credit Risk. Investopedia. 2009. Web.

Horcher, Karen. Essentials of financial risk management. New Jersey: John Wiley and Sons, 2005. Print.

McNeil, Alexander., Frey, Rüdiger., and Embrechts, Paul. Quantitative risk management: concepts, techniques and tools. New Jersey:Princeton University Press, 2005. Print.

Pietersz, Graeme. Risk Free Rate. Money Terms. 2005. Web.

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