The standard deviation of returns on Wildcat Oil Drilling is very high. Does thi

Question

The standard deviation of returns on Wildcat Oil Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

The equation for beta in Chapter 8 shows that the nondiversifiable risk of an asset is the product of its standard deviation of returns and the correlation of those returns with those on a well-diversified portfolio. Wildcat Oil Drilling may have a high standard deviation of returns, but if those returns are poorly correlated with those on a well-diversified portfolio, as is likely the case, nondiversifiable risk may be low. In other words, if investors can diversify away most of Wildcat’s risk, then it is not truly a high-risk investment.

Explanation / Answer

This doesnot recessarily mean that it is a high risk investment because large part of the risk might be systematic risk can be diversified away by holding it as a part of a portfolio wherein the covariances between the individual securities are less thus reducing the overall standard deviation of the portfolio.

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