Volatility and the Risk Premium of a Single Stock

This video shows why you should not use volatility to determine the risk premium of a single stock. Volatility is a measure of total risk, which includes both market risk (systematic risk) and firm-specific risk (unsystematic risk). Because firm-specific risk can be diversified away, investors do not demand a risk premium for holding it. Thus, the important factor in determining the risk premium (and thereby the cost of capital) for a single stock is to use a measure of market risk (beta). This is not to say that volatility is unimportant; the volatility of a portfolio of stocks, for example, comes into play with the Sharpe Ratio. The Sharpe Ratio enables investors to calculate how much excess return they can expect to receive per unit of volatility.

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