Question

How is Risk measured? Also, what Beta is and how we calculate it, what correlation is, and how all of this helps us design efficient market portfolios?

Answer 1

Risk is measured by standard deviation. Standard deviation is used to measure the risk of a portfolio or an asset.

Beta is a measure of systematic risk that measures the fluctuation of the stock and is also used in CAPM model to calculate the cost of equity.

Beta is calculated by dividing covariance by Variance of market.

Beta = Covariance / variance of market

Correlation is a measure of how two securities move in relation to each other. It also measures the strength of the relation. The range varies between +1 to -1 . +1 mean perfectly correlated, -1 mean negatively correlated and 0 means uncorrelated.

In order to design efficient portfolio, we need standard deviation, beta and correlation. The higher the correlation, the higher would be the risk and beta. This helps to know the optimal portfolio as per the risk of the investor. If investor is risk averse, then he will diversify his portfolio by investing in assets which are negatively related , which in turn reduces risk i.e. standard deviation and beta.

These three together help us to make optimal and efficient portfolio as per the risk of the investor, and also help us to recognize whether our potfolio is optimal or not.