Question

Make distinctions between the standard deviation and beta in the measurement of risk in the capital market. Which one of these two metrics (standard deviation and beta) is relevant for measuring the risk of well-diversified portfolio? Explain why

Answer 1

Standard deviation measure overall standalone risk of a firm. it is calculated by the square root of sum o squares of deviation of returns from the means. Standard deviation includes both systematic and unsystematic risk.

Beta is the measure of market risk k. It is calculated by the covariance of returns with market divided by variance of market returns.Beta measures the systematic risk of the firm.Higher the beta, higher the market risk of firm and returns of such stocks are higher when there is boom and return of such stocks fall when there is recession.

Beta is better measure for measuring risk of well diversified portfolio. as diversification reduces unsystematic risk but systematic risk cannot be diversified away. Moreover as per CAPM the stocks provide return which compensates for only systematic risk.