A company faces two kinds of risk. A firm-specific risk is...

Name: Problem 7, Chapter 27: Principles of Economics
Uploaded: 2021-04-12T21:39:30-08:00
Duration: 1 min 33 s
Channel: Kaylee Mcclellan
Description: A company faces two kinds of risk. A firm-specific risk is that a competitor might enter its market and take some of its customers. A market risk is that the economy might enter a recession, reducing sales. Which of these two risks would more likely cause the company's shareholders to demand a higher return? Why?

A company faces two kinds of risk. A firm-specific risk is that a competitor might enter its market and take some of its customers. A market risk is that the economy might enter a recession, reducing sales. Which of these two risks would more likely cause the company's shareholders to demand a higher return? Why?

A company faces two kinds of risk. A firm-specific risk is that a competitor might enter its market and
take some of its customers. A market risk is that the economy might enter a recession, reducing sales.
Which of these two risks would more likely cause the company's shareholders to demand a higher return? Why?

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Key Concepts

Systematic Risk

Systematic risk refers to the broad market risk that affects all companies, typically caused by macroeconomic factors such as recessions, interest rate changes, or geopolitical events. This type of risk is non-diversifiable, meaning that it cannot be eliminated through portfolio diversification, and therefore investors require a higher return as compensation for bearing this unavoidable risk.

Diversifiable (Idiosyncratic) Risk

Diversifiable risk pertains to risks that are specific to a company or industry, such as a competitor entering the market. Because these risks are unique to an individual firm or a small group of firms, they can be mitigated or eliminated by holding a diversified portfolio. As a result, investors do not usually demand a higher return specifically for this kind of risk.

Risk Premium

The risk premium is the additional return that investors expect to receive for taking on extra risk beyond a risk-free investment. Since systematic risk cannot be diversified away, it generally necessitates a higher risk premium compared to diversifiable risk.

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