- Treasury bonds are considered the most safe investment available since they are backed by the U.S. government. Treasury bonds are used as a benchmark when determining the risk of other investments because they are considered to provide a risk free rate of return.
- The risk premium of a stock is defined as the potential return of the stock minus the return of a treasury bond. For example, if a treasury bond provides a return of 3 percent and an investor predicts that a stock will return 5 percent, then the risk premium is 2 percent.
- The risk premium allows an investor to understand the risk-reward payoff of investing in a stock. After analyzing the potential appreciation of a stock as well as the risks involved, an investor can decide if the risk is worth the extra reward, which is the risk premium.
- One type of risk that should be considered when investing in a stock is company specific risk. Company specific risk relates to the performance of the company, the company's management, and even the competitive landscape in which the company must operate.
- Another risk is market risk, which refers to the risk associated with the stock market in general. If the stock market declines for any reason, there is a large probability that the stock of a particular company will also decline. Market risk is not in the control of company management, but it is still important to consider before making an investment.
- Stock prices are also subject to geo-political risk. Political decisions, changes in governments, and new regulations can all affect a stock's value.
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