(Solution) Finance Project The Relationship Between Risk and Cost of Capital
Solution
Abstract
This report critically analyzes how risk and the cost of capital are linked among firms in Saudi Arabia, with particular emphasis on the different roles played by systematic and unsystematic risks. It looks into known financial theories such as Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), and evaluates their application to the Gulf financial markets. The report examines the sector-specific risks, specifically within the oil and banking sector, and how they affect the cost of capital of particular firms, as well as the distinctive risk-return dynamics of Sharia-compliant finance structures. An analysis of empirical literature points towards the pricing of risk in emerging markets and reforms that need to be undertaken with respect to markets that are highly volatile and have concentrated ownership structures. Chosen case studies of major Saudi companies illustrate the influence of the market risk, sector exposure, and regulatory restrictions on corporate financial strategies. The report sums up by making recommendations on financial policy enhancement and risk management activities that comply with Vision 2030 policies of Saudi Arabia.
Contents
4.1 Effects of Systematic and Unsystematic Risks on the Cost of Capital for Firms in Saudi Arabia 6
4.2 Review of Key Theories: CAPM and APT. 6
4.3 Empirical Evidence on How Gulf Financial Markets Price Risk. 7
4.4 Influence of Sector-Specific Risk on Cost of Capital 8
4.5 Influence of Sharia-Compliant Finance on Risk-Return Dynamics 9
5.0 Review of Selected Cases 10
7.0 Conclusion and Recommendations. 12
1.0 Introduction
The cost of capital is an important concept in corporate finance because it helps shape investment, financing and overall business strategy decisions at the firm level. Following a definition provided by Kurniasih et al. (2022), it is the minimum that a company has to provide in its returns so that the company could please its investors and stay economically stable. One of the influencing factors of cost of capital is risk, which impacts on both the returns that an investor would demand, and the circumstances in which companies can obtain capital. Here, risk is commonly categorized into two main categories namely: systematic and unsystematic risks whereby, systematic risk, as defined by Renn et al. (2020), impacts the market or economy at large and unsystematic risk impacts only firm, industry, or sector (Roman, 2019).
It is particularly crucial to determine the correlation between risk and cost of capital in new and dynamic markets like the Saudi Arabian market. Due to significant economic changes that the country is undertaking under its Vision 2030 plan, which is expected to promote economic diversification and limit reliance on oil, as well as stimulate the development of the country to focus on the role of the private sector, the financial markets are changing (Khoirunnisa & Nurhaliza, 2024). The emergence of new investment opportunities, regulatory changes as well as greater openness of the markets have all influenced the manner in which risk is perceived and priced. The financial system in Saudi Arabia is also exceptional, as it incorporates conventional finance along with Sharia-compliant financial products with differing risk-return profiles and implications for corporate financing (Boulanouar et al., 2024).
The aim of this report is to explore how different types of risks affect the cost of capital of Saudi Arabian companies. It will begin by evaluating critical financial theories like the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) and continue with the discussion of risk pricing in Saudi and the Gulf markets.
The paper will also be looking at sector specific risk, like the oil and bank sectors, and how Islamic financial principles impact the connection between risk and cost of capital. Lastly, the paper provides conclusions and recommendations, based on the findings.
2.0 Background
The connection between risk and the cost of capital has been a major concern in financial management and it determines how firms acquire funds, invest their resources, and pursue investment opportunities. Kurniasih et al. (2022) explain that a cost of capital is a reflection of expected returns of those who provide funds to a company, either in the form of equity, debt, or other instruments. Saalmuller (2022) also states that it acts as a measure or standard by which companies test the viability of possible projects. One key element of this computation is the risk that is involved in the operations of the firm and the market environment in general. Rao et al. (2022) assert that the greater the perceived risk by investors, the higher the returns they demand to unlock the capital, and subsequently, there are impacts on the cost of raising capital by a company.
Risk that influences the cost of capital of a firm can be classified either as systematic or unsystematic. Systematic risk (also known as market risk) is caused by external situations like inflation, interest rate fluctuations, oil prices and political stability, which impact all the companies in an industry to a certain extent (Renn et al., 2020). Unsystematic risk is, by contrast, caused by factors unique to a firm or industry, such as, management, operational, or competition. Although unsystematic risk is addressed through diversification, systematic risk is mostly unavoidable and of primary concern to the investors and financial managers (Roman, 2019).
These risks are especially dominant in the Saudi Arabian context, given its economic system and other current reforms with Vision 2030. Historically dependent on the oil industry, Sarwar (2022) notes that the economy is currently experiencing massive reforms as a way to encourage diversification, enhance regulatory systems, and attract foreign investment. Furthermore, how risk is measured and priced is complicated by the existence of conventional and Sharia-compliant systems of finance (Nugroho, 2023). All these aspects necessitate a review of the influence of various risks on the cost of capital in the Saudi firms, especially in the major sectors such as oil, banking and real estate.
3.0 Research Objectives
- To critically examine the relationship between financial risk and the cost of capital for firms in Saudi Arabia, focusing on how both systematic and unsystematic risks influence financing decisions and investment strategies in an emerging market context.
- To review and assess key financial theories, including the CAPM and the APT, analyzing their assumptions, limitations, and applicability to capital markets in Saudi Arabia.
- To evaluate empirical studies and evidence on how risks are priced in Gulf financial markets, with particular attention to factors such as market volatility, ownership structures, and economic dependency on specific sectors like oil and banking.
- To explore the impact of sector-specific risks on the cost of capital, identifying how industries such as oil, banking, and real estate manage financial risk and determine their capital structure and financing costs.
- To investigate how Sharia-compliant financial products and principles affect risk-return dynamics and influence the cost of capital for firms, considering the unique features and restrictions of Islamic finance compared to conventional financial systems.
- To provide conclusions and recommendations for financial managers, policymakers, and investors, offering insights into effective risk management and capital cost strategies in light of ongoing economic reforms under Saudi Arabia’s Vision 2030.
4.0 Literature Review
4.1 Effects of Systematic and Unsystematic Risks on the Cost of Capital for Firms in Saudi Arabia
Risk is an important element in corporate finance because it influences the costs of capital through the determination of the level of expected returns desired by the investors. In relation to Saudi Arabia, both the risk types contribute greatly to the cost of capital. The systematic risks are particularly prominent since the economy heavily relies on oil and the government is undertaking economic reforms under the vision 2030 (Asafo-Adjei et al., 2022). For example, the Saudis stock market has always been highly volatile due to the changing global oil prices directly affecting the systematic risk borne by investors. Systematic risk in the region is further fueled by political developments, regulatory reforms, and changes in the global economic conditions (Alhejaili, 2024).
Unsystematic risk, though it can be addressed through diversification, is also significant in a market such as Saudi Arabia where concentrated ownership structures and family-owned businesses are common. As illustrated by Lasloom (2021), firm-specific risks are highly dependent on corporate governance practices, financial transparency, and operational performance. Unsystematic risks are commonly associated with strategic choices, management skills, and internal funding policies because of the prevalence of large, state-influenced or family-run enterprises (Kedarya et al., 2023). Consequently, investors pay increased attention to these factors in their decision of expected returns, which ends up reflecting on the cost of capital for firms.
Considering the interconnected nature of both types of risks in the emerging markets, Saudi companies need to be cautious in handling not just the external risk factors associated with the market, but also the internal risks associated with the operations. As financial managers seek to secure competitive capital costs, more sophisticated and advanced risk assessment and mitigation measures are needed.
4.2 Review of Key Theories: CAPM and APT
The relationship between risk and return has long been explained through foundational financial models, the most notable being the CAPM and the APT.
According to Vergara-Fernández et al. (2023), the CAPM model suggests that the expected return on an asset is directly proportional to its systematic risk, measured by beta (β). Beta here, is the responsiveness of the returns of a firm to the overall returns of the market. The model suggests that unsystematic risk in well-diversified portfolios can be eliminated, and thus it is only systematic risk that affects the cost of capital (Kumar et al., 2023). Nonetheless, despite its popularity because of simplicity, Mandala et al. (2023) cautions about the assumptions made by the model about market efficiency, rationality of investors, and single-period investment horizon.
The CAPM is highly limited in emerging markets such as Saudi Arabia. According to Anuno et al. (2023), risk-return relationships may be distorted by market inefficiencies, concentrated ownership, and lower levels of market integration. However, Kenton (2024) admits that the model remains a useful starting point for estimating the cost of equity, especially when supplemented with market-specific adjustments.
The APT model offers a more flexible alternative to CAPM by allowing multiple factors to influence asset returns. Rather than relying solely on market risk, APT considers various macroeconomic, industry-specific, and firm-level factors that may affect expected returns (Didisheim et al., 2024). This multi-factor approach is particularly relevant in Saudi Arabia, where market returns are influenced by oil prices, government policies, and regional political stability, alongside traditional financial indicators.
APT’s ability to incorporate multiple risk factors makes it an attractive model for assessing the cost of capital in complex financial environments (Hayes, 2024). However, its practical application is often limited by the difficulty of identifying relevant factors and obtaining reliable data in less transparent markets (CFI, 2024).
4.3 Empirical Evidence on How Gulf Financial Markets Price Risk
Studies highlight the exceptional market characteristics of the Gulf region such as its volatility, being oil dependent, and the mixture of traditional and Islamic finance systems. A study conducted by Kolari et al. (2021) tested the CAPM in Saudi Arabia and reported that market risk has a considerable impact on stock returns, but the explanatory power of beta is relatively weak when compared to the developed countries. This means that there are other numerous risk factors, which are either unsystematic or macroeconomic influencing asset pricing. Subsequent studies conducted by Narayany et al. (2025) examined risk pricing in GCC markets and obtained similar findings, noting that market conditions and regulatory restrictions limit the predictive capabilities of the CAPM.
Hassan et al. (2020) conducted another study in which they explored the integration of the principles of Islamic finance into the capital markets and the effect those principles had on the risk pricing. Their findings confirmed that Sharia-compliant stocks in Saudi Arabia were observed to be less volatile and with different risk-return profiles compared to conventional stocks, largely due to their prohibition of interest-based transactions and speculative investments. This implies that risk pricing in the Saudi financial markets should consider the distinct attributes of the two financial systems.
These empirical findings underline the importance of adopting flexible and multi-dimensional approaches to risk assessment in the Gulf region. Financial managers must consider not only market-wide factors but also sector-specific and religious compliance factors when estimating the cost of capital.
4.4 Influence of Sector-Specific Risk on Cost of Capital
The impact of sector-specific risk on the cost of capital is particularly evident in Saudi Arabia’s key industries, such as oil, banking, and real estate (Razek & McQuinn, 2021). Each sector faces unique risks that affect investor expectations and capital costs.
The Saudi economy has long been dependent on the oil industry which is quite vulnerable to changes in the global oil prices. In this context, Soummane et al. (2022) bring to light the fact that drastic price fluctuations affect the revenues of firms, state expenditures, and the performance of the whole economy, leading to a change in the level of systematic risk. Increased perceived risk among firms in this sector, because of price volatility, implies increased cost of equity and debt financing (Sweidan & Elbargathi, 2023). Moreover, risk premiums required by investors are also worsened by geopolitical tensions in the Middle East (Belloumi et al., 2023).
The banking sector, although enjoying strong regulatory control by the Saudi Central Bank (SAMA), is exposed to the risk of credit exposure, interest rate fluctuations, and market liquidity. Banks, as financial intermediaries, are directly affected by macroeconomic conditions and monetary policy changes (Orlando & Bace, 2021). Risk perceptions and cost of capital among Saudi banks have also been affected by the implementation of new financial regulations that seek to enhance transparency and attract foreign investment.
The real estate industry is also subject to risks such as changes in the market demand, regulatory framework, and the accessibility to financing sources. Both opportunities and uncertainties have been introduced by the government housing schemes and economic diversification strategies. As Deep et al. (2021) remark, such sector-specific risks require investors to have higher return expectations from investors, thus raising the cost of capital for firms operating in these industries.
Given the diverse risk profiles across sectors, Saudi firms must adopt tailored financial strategies to manage sector-specific risks effectively. Bhattacharyay (2021) mentions that this includes diversifying revenue streams, employing hedging techniques, and maintaining prudent capital structures to mitigate adverse impacts on financing costs.
4.5 Influence of Sharia-Compliant Finance on Risk-Return Dynamics
The financial system of Saudi Arabia is characterized by the coexistence of conventional and Sharia-compliant financial products. In Islamic finance where interest (riba) and extreme uncertainty (gharar), speculative transactions (maysir) are unlawful, risk-return dynamics are unique, and this impacts the cost of capital (Mahadewi, 2024).
Under the Sharia-compliant finance, there is a sharing of risk between financiers and the borrowers in the equity-based contract such as the mudarabah (profit-sharing) and musharakah (joint ventures). Adams et al. (2023) remark that the principle of risk-sharing can lead to stabilization of financial relations, but in this case, the cost of capital can rise due to a higher degree of due diligence and profit sharing. Furthermore, the prohibition against interest allows the use of asset-based securities, including the sukuk, to substitute the traditional concepts of debt (Brahmana & Kontesa, 2023). Although sukuk have fixed returns similar to bonds, they have different underlying asset structures and regulatory requirements that can influence pricing and risk assessments.
In empirical literature, Sharia-compliant firms have been found to exhibit reduced volatility in stock returns and different cost of capital profiles compared to traditional firms. Al‐Yahyaee et al. (2020) noted that Islamic funds in Saudi Arabia have demonstrated smaller beta values, meaning that these funds are characterized by a lower exposure to systematic risk. Al-Gasaymeh et al. (2021) suggest that this may be due to their exclusion from high-risk financial activities and speculative markets.
Nonetheless, disadvantages like lower liquidity and restricted investment options on Islamic financial markets may raise the cost of capital for firms operating exclusively within Sharia-compliant frameworks (Hassan et al., 2021). Low market depths and increased trading costs can make investors demand increased risk premiums.
With Saudi Arabia pursuing the modernization of their financial sector and Vision 2030 goals, the integration of conventional and Islamic finance is expected to transform the capital markets (Alhammadi, 2024). To optimize the capital costs and the investment strategy of their firms, financial managers need to accurately balance the differing risk-return expectations of these systems.
5.0 Review of Selected Cases
In this section, a number of corporate cases are examined with the aim of addressing the relationship between risk and cost of capital in Saudi Arabia. The chosen companies are Saudi Aramco, Al Rajhi Bank and Dar Al Arkan, which represent various industries of oil production, banking sector and real estate businesses respectively, critical to the country’s economic landscape and highly sensitive to both systematic and unsystematic risks.
A significant example of the impact of the systematic risk on the cost of capital is presented by the Saudi Aramco which is the largest oil producer in the world. Since Aramco is susceptible to changes in global oil prices and geopolitics, the financial strategy is driven by its ability to maintain a strong credit rating and conservative debt policies to manage investor expectations (Hajiyev et al., 2024). In 2019, the company made history with its landmark IPO the largest ever, which was priced cautiously in order to suit the volatility of the market and geopolitical instability in the region. Through substantial cash flows and government backing, Al-Sahali & Al-Adeem (2024) report that Aramco managed to secure a relatively low cost of capital despite high systematic risk, demonstrating the mitigating effect of state support and strategic financial planning.
Al Rajhi Bank represents the banking sector, where both market-wide and industry-specific risks influence capital costs. As one of the largest Islamic banks globally, it operates within Sharia-compliant financial frameworks, which shape its risk-return profile (Alrajhi Bank, 2025). The bank’s risk exposure is driven by credit risks, regulatory changes, and interest rate policies. Its financial performance has remained robust, largely due to its focus on retail banking, a diversified income base, and adherence to conservative lending practices (Alali & Haddad, 2023). By aligning with Islamic finance principles and maintaining solid governance, Sidaoui et al. (2022) mention that Al Rajhi has achieved lower risk premiums and stable capital costs compared to some of its conventional counterparts.
Dar Al Arkan, a major real estate developer, illustrates how unsystematic and sector-specific risks affect financing costs. The real estate sector in Saudi Arabia is influenced by government housing initiatives, regulatory reforms, and fluctuating demand (AlQahtany, 2021). Dar Al Arkan’s financing strategy involves a mix of sukuk issuances and equity financing, balancing Sharia-compliant obligations with market opportunities (DAR AL ARKAN, 2025). The company faced increased capital costs during periods of economic uncertainty and regulatory adjustments but managed to stabilize its financial position through strategic asset sales and project diversification. This case underscores the importance of adaptive financial management in navigating sector-specific risks.
The comparison of these cases shows consistent trends on how firms that actively manage risk by diversification, good governance and alignment with regulatory frameworks have a tendency of attracting lower cost of capital, even in the high-risk environment. Nevertheless, financial strategies are developed under the influence of sector-specific risks, with oil and banking companies relying on cash flow fluctuations and regulatory compliance, whereas real estate developers face risks that can be associated with market demand and policies changes.
These cases also reinforce theoretical insights from the CAPM and APT frameworks. While CAPM’s emphasis on systematic risk is evident in Aramco’s exposure to market-wide factors, APT’s multi-factor approach is better suited to explaining the diverse influences on Al Rajhi Bank and Dar Al Arkan. The influence of Sharia-compliant finance on risk-return dynamics is apparent across all cases, highlighting lower volatility and unique financing structures.
6.0 Key Findings
The report has developed several essential findings regarding the relationship between risk and cost of capital of firms operating in Saudi Arabia. Considering
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