Question: What is the cost of risk in the following example?
Investment A is a $10,000 loan that will return 4% per year.
Investment B is a $10,000 equity investment that is expected to return 10% per year
1. **State the problem:** We want to find the cost of risk, which is the additional return expected from a risky investment compared to a risk-free or less risky investment.
2. **Identify the investments:**
- Investment A: Loan of $10,000 with a 4% annual return (considered less risky).
- Investment B: Equity investment of $10,000 with an expected 10% annual return (riskier).
3. **Formula for cost of risk:**
$$\text{Cost of Risk} = \text{Return on Risky Investment} - \text{Return on Risk-Free Investment}$$
4. **Apply the formula:**
$$\text{Cost of Risk} = 10\% - 4\% = 6\%$$
5. **Interpretation:**
The cost of risk is 6%, meaning the equity investment is expected to yield 6% more per year than the loan to compensate for the additional risk.
**Final answer:** The cost of risk is $6\%$.