The ________ is responsible for differences in the required rates of return among alternative investments.
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A. B. C. D.D
Investors demand higher return for riskier investments and thus require a higher rate of return on them.
The correct answer is D. risk premium.
The risk premium is responsible for differences in the required rates of return among alternative investments. It represents the additional return that investors demand for taking on additional risk compared to a risk-free investment, such as a government bond or Treasury bill.
Investors expect to be compensated for the risk they assume when investing in assets that have uncertain future returns. The risk premium is the compensation they require to hold these riskier investments. It is added to the risk-free rate of return to determine the required rate of return for a particular investment.
The risk premium can vary depending on several factors, including the type of investment, its risk characteristics, and market conditions. Generally, investments that are perceived as more risky or volatile will have higher risk premiums, while investments that are considered safer will have lower risk premiums.
For example, let's say there are two investment options: Option A, which is a government bond with a fixed return of 4%, and Option B, which is a stock with a historical average return of 8% but higher volatility. Investors will require a risk premium above the risk-free rate (let's assume it's 2%) to invest in Option B. Therefore, the required rate of return for Option B would be 6% (4% risk-free rate + 2% risk premium).
The risk premium reflects the investor's expectation of compensation for bearing the additional risk associated with an investment. It is an important concept in finance and plays a crucial role in determining the valuation and attractiveness of different investment opportunities.