Question

Suppose that the standard deviation of the returns on the shares of stock at two different companies is exactly the same. Does this mean that the required rate of return will be the same for these two stocks? How might the required rate of return on the stock of a third company be greater than the required rates of return on the stocks of the first two companies even if te standard deviation of the returns of the third company's stock is lower?

Answer 1

Standard deviation measures total risk-systematic and unsystematic risk. One gets compensated only for systematic risk because unsystematic risk can be diversified away. Therefore, required return only depends on systematic risk or the sensitivity to the market.

So required return will not necessarily be the same for two stocks-It will be the same only when they both have same systematic risk or beta or correlation with market.

The third company might have higher beta or higher correlation with the market. So even if standard deviation is lower required return might be higher.