Week 5 Forum 2

Risk Premium
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Risk Premium
Any investment attracts some risk. A risk is defined as the probability of an undesirable outcome occurring. Investors expect compensation for undertaking risk. The compensation has to be reasonable enough to compel an investor to risk their money. There exist two types of risks when it comes to investing – systematic and unsystematic.
Systematic risk is the risk affecting all the securities in the market. The day-to-day variation of the price of stocks constitutes systematic risk (Hassett, 2011). Elements such as wars and interest rates are sources of systematic risk since their effect is felt by all securities in the market. Hedging is the only way to mitigate systematic risks. Hedging entails investing in an asset to reduce the adverse price movement of another asset. In retrospect, unsystematic risk is the risk linked to a specific company or industry that an investor commits their money (Hassett, 2011). For instance, an employee strike in a given company with publicly traded stocks is considered an unsystematic risk. Diversification is used to mitigate an unsystematic risk.
The amount by which the returns from investment in a given asset exceed the returns from investment in assets that are not risky is known as risk premium (Hassett, 2011). Thus, the risk premium is the reward enjoyed by an investor for willing to commit money in a risky asset. A prime example of a risk-free asset is a US Treasury Bill while stocks are prime examples of risky assets.

Therefore, investors who bear systematic risks enjoy a risk premium while investors who bear unsystematic risks do not enjoy a risk premium. Investors who take on systematic risk are rewarded with a risk premium since they are at a greater risk of making a loss on their investment compared to investors who take on unsystematic risks (Hassett, 2011).
Reference
Hassett, S. D. (2011). The risk premium factor: A new model for understanding the volatile
forces that drive stock prices. (The risk premium factor.) Hoboken, N.J: Wiley.