Question

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?

Answer 1

A firm-specific risk refers to the individual risk of each company within an industry or sector. Such risks can be diversified away. It also refers to an event that would directly affect the market value of an asset or group of assets. It is the risk that affects only a single company.

Market risk is defined as the risk that occurs due to fluctuations in the market. Market risk refers to risks that are common to whole economy. These risks cannot be diversified away. It affects all the companies in the stock market.

________________________________________________________________________It is know that higher is the element of risk, higher is the potential returns. Since a firm specific risk have more adverse impact than a market risk, shareholders of a company expects higher returns due to company’s firm-specific risk. This is because shareholders would like to demand higher return due to stock’s firm specific risk.

Therefore, A firm-specific risk is more likely to cause the company’s share holders to demand a higher return.