Answer to Question #169417 in Macroeconomics for Ashly Ceja

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

We know from the text that firm-specific risk can be protected against by diversification, while market risk cannot be protected as it will affect every firm in a certain market.

The firm has no control over the market risk as the firm cannot control the market factors. Firm-specific risk on the other hand can be addressed and shareholders may demand higher returns if there is a new firm-specific risk like a new competitor entering the market.

Therefore, a firm-specific risk would more likely cause the company’s shareholders to demand a higher return.