1. Spectrum of risk
All investments exist on a spectrum of risk, the lowest risk asset is
usually a government bond like the United States Treasury Bond.
Governments can default on their obligations, it is incredibly rare for
a large, highly rated country to default on its debt.
Because this is the lowest risk asset the required rate of return is
the lowest as well. Further up the risk spectrum, you have company or
corporate debt, since companies cannot print dollars, companies are riskier
than the US Treasury Bond, for example. Therefore, the required rate of
return will be higher than the risk free return.
And at the top of our spectrum, we have equity,
since company debt represents a legal claim on a company's assets,
debt is less risky than equity. Equity only has value once the debt
claim is satisfied, therefore, equity will have a higher required rate of
return than the company debt.
2. Let's practice!