Question

The required rate of return in valuing an asset is based on the risk involved. Identify two types of risk that affect investments and briefly describe them.

Answer 1

The required rate of return in valuing an asset is based on the risk involved. Identify two types of risk that affect investments and briefly describe them.

The two types of risk that affect the investments are:

1. Systematic risk
2. Unsystematic risk

Systematic risk is also called the market risk. This risk affects not only our investment but also other investments in the market. Examples include rise in interest rates, rise in corporate taxes, additional environmental impact costs, etc.

Systematic risk cannot be diversified away.

Unsystematic risk is the firm-specific risk. This risk affects only our investment and not other investments in the market. Examples include whistle blower complaint against the company's CEO, unexpected resignation of key executives of the company, etc.

Unsystematic risk can be diversified away by investing in many stocks.