Question

The benchmark for a well-diversified stock portfolio is the market portfolio, which is a portfolio containing all stocks. The relevant risk of an individual stock is measured by its beta coefficient, which is defined under the Capital Asset Pricing Model (CAPM) as the amount of risk that the stock contributes to the well-diversified portfolio. Based on your understanding of the CAPM and beta, answer the following question: Which of the following statements about stock's correlation with the market is true? O A stock with low stand-alone risk will tend to destabilize the portfolio O A stock with a low correlation with the market is risky. A stock with a high correlation with the market is risky.

Please answer

Answer 1

The overall risk of portfolio can be minimised by adding stock with low correlation with each other i.e in a well deveraified portfolio risk can be kept at minimum level.

In context of above statements, 3rd statement is true.

It is stated that stock with high correlation with the market will be more risky, provided the above said correlation is positive. It means that both market and stock move in the same direction, this will result in high standard deviation for the portfolio. It is the standard deviation measure only that signifies the RISK factor i.e. it is risk determinant of stock or portfolio.