QN01.

The five main risks that comprise the risk premium are business risk, financial risk,

liquidity risk, exchange-rate risk, and country-specific risk. These five risk factors all have the
potential to harm returns and, therefore, require that investors are adequately compensated for
taking them on

Business Risk
Business risk is the risk associated with the uncertainty of a company's future
cash flows, which are affected by the operations of the company and the
environment in which it operates. It is the variation in cash flow from one period
to another that causes greater uncertainty and leads to the need for a greater risk
premium for investors. For example, companies that have a long history of stable
cash flow require less compensation for business risk than companies whose
cash flows vary from one quarter to the next, such as technology companies. The
more volatile a company's cash flow, the more it must compensate investors.

Financial Risk
Financial risk is the risk associated with a company's ability to manage the
financing of its operations. Essentially, financial risk is the company's ability to
pay its debt obligations. The more obligations a company has, the greater the
financial risk and the more compensation is needed for investors. Companies
that are financed with equity face no financial risk because they have no debt
and, therefore, no debt obligations. Companies take on debt to increase their
financial leverage; using outside money to finance operations is attractive
because of its low cost.

The greater the financial leverage, the greater the chance that the company will
be unable to pay off its debts, leading to financial harm for investors. The higher
the financial leverage, the more compensation is required for investors in the
company.

Liquidity Risk
Liquidity risk is the risk associated with the uncertainty of exiting an investment,
both in terms of timeliness and cost. The ability to exit an investment quickly and
with minimal cost greatly depends on the type of security being held. For
example, it is very easy to sell off a blue-chip stock because millions of shares
are traded each day and there is a minimal bid-ask spread. On the other hand,
small cap stocks tend to trade only in the thousands of shares and have bid-ask
spreads that can be as high as 2%. The greater the time it takes to exit a position
or the higher the cost of selling out of the position, the more risk premium
investors will require.
Exchange-Rate Risk
Exchange-rate risk is the risk associated with investments denominated in a
currency other than the domestic currency of the investor. For example, an
American holding an investment denominated in Canadian dollars is subject to
exchange-rate, or foreign-exchange, risk. The greater the historical amount of
variation between the two currencies, the greater the amount of compensation
will be required by investors. Investments between currencies that are pegged to
one another have little to no exchange-rate risk, while currencies that tend to
fluctuate a lot require more compensation.

Country-Specific Risk
Country-specific risk is the risk associated with the political and economic
uncertainty of the foreign country in which an investment is made. These risks
can include major policy changes, overthrown governments, economic collapses,
and war. Countries such as the United States and Canada are seen as having
very low country-specific risk because of their relatively stable nature. Other
countries, such as Russia, are thought to pose a greater risk to investors. The
higher the country-specific risk, the greater the risk premium investors will
require.