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- The risk associated with a common stock is interpreted in terms of the variability of its return. The most common measures of riskiness of security are standard deviation and variance of returns.
- Unsystematic risk is the extent of the variability in the security's return on account of the firm specific risk factors. This is also called diversifiable or avoidable risk factors.
- Systematic risk refers to factors which affect the entire market and hence the firm too. This is also called non-diversifiable risk.
- If a portfolio is well diversified, the unsystematic risk gets almost eliminated. The non-diversifiable risk arising from the wide movements of security prices in the market is very important to an investor. The modern portfolio theory defines the riskiness of a security as its vulnerability to market risk. This vulnerability is measured by the sensitiity of the return of the security vis-a-vis the market return and is called beta.
- The concept of security market line is developed by the modern portfolio theory. SML represents the average or normal trade-off between risk and return for a group of securities. Here the risk is measured typically in terms of the beta values.
Application of Security Market Lines:
The ex post SML is used to evaluate the performance of portfolio manager, tests of asset-pricing theories, such as the CAPM and to conduct tests of market efficiency.
The ex ante SML is used to identify undervalued securities and determine the consensus, price of risk implict in the current market prices.
Depending upon the value of alpha, suing SML it is possible to estimate whether the scrip is under-priced(it is then eligible to be purchased) or overpriced (it is then eligible to be sold).