Financial issues: loans, mortgage, investment

A risk-free investment was defined as one for which the investor is certain of the amount and timing of the expected returns. The returns from most investments do not fit this pattern. An investor typically is not completely certain of the income to be received or when it will be received. Investments can range in uncertainty from basically risk-free securities, such as T-bills, to highly speculative investments, such as the common stock of small companies engaged in high-risk enterprises.
Most investors require higher rates of return on investments if they perceive that there is any uncertainty about the expected rate of return. This increase in the required rate of return over the NRFR is the risk premium (RP). Although the required risk premium represents a composite of all uncertainty, it is possible to consider several fundamental sources of uncertainty. In this section, we identify and discuss briefly the major sources of uncertainty, including: (1) business risk, (2) financial risk (leverage), (3) liquidity risk, (4) exchange rate risk, and (5) country (political) risk.

If investors expected the price level to increase during the investment period, they would require the rate of return to include compensation for the expected rate of inflation. Assume that you require a 4 percent real rate of return on a risk-free investment but you expect prices to increase by 3 percent during the investment period. In this case, you should increase your required rate of return by this expected rate of inflation to about 7 percent [(1.04 × 1.03) – 1]. If you do not increase your required return, the $104 you receive at the end of the year will represent a real return of about 1 percent, not 4 percent. Because prices have increased by 3 percent during the year, what previously cost $100 now costs $103, so you can consume only about 1 percent more at the end of the year [($104/103) – 1]. If you had required a 7.12 percent nominal return, your real consumption could have increased by 4 percent [($107.12/103) – 1].