Question

a) what are the two most commonly used measures of risk in finance. How are they related to each other?

b) why risk premium for assets (stocks) is determined by its systematic risk only?

Assume, we hold well-diversified portfolio of 40 stocks and we are adding random 5 stocks to it. How will addition of these stocks affect expected return of the portfolio? Volatility (standard deviation) of the portfolio?

Answer 1

a) There are various tools used in finance to measure risk:

First is the Standard deviation. It is basically the deviation from the benchmark or the expected value. Higher the standard deviation, higher the volatility and in turn higher the risk assosiated.

Beta is another tool to measure the risk, specifically the systemic risk which an investor cannot diversify. Higher the beta, more the volatility of the stock, more is the risk

b) Risk premium for stocks is determined by systematic risk because this is the risk which cannot be diversified. This is the risk which is not in the hand of investor and he / she cannot do anything about it. Unsystematic risk is company and industry specific and can be diversified by the investor, so this is not the actual risk teh investor faces

Adding more stocks to the portfolio will definately help the investor to increase the overall return of the portfolio and reduce the risk. But it depends upon what kind of stock we are adding in the portfolio. Adding randomly 5 stocks to the portfolio can have different effects. If the stocks are from different industry and are complemeting the stocks which are already there in the portfolio, the risk of the overall portfolio will definately will drop decreasing the volatility of the portfolio. But if these randoms stock are from say loss making and are from same industry as other stock are, this case will decrease our return but will not effect the volatility much.