The risk or variation in return of a security is caused by two types of factors. The first type of factors will affect the return of almost all securities in the market. Examples of such sources of risks are changes in the interest rates and inflation of the economy, movement of stock market index and exchange rate movement. The risk caused by such factors is known as systematic risk. Apart from systematic risk, the variation in return of a security is also caused by some other factors which are specific to a security, like strike in a company or caliber of the management of a company. The risk caused by such factors is known as unsystematic or specific risk. The unsystematic risk of a security can be diversified away by combining different securities into a portfolio. But systematic risk cannot be diversified away by construction of a portfolio. So the real risk of a security is the systematic risk as the investors can diversify the unsystematic risk by construction of a portfolio. The systematic risk of a security is measured by a statistic known as beta. The beta of a security measures the sensitivity of a security’s return to changes in the return of the market portfolio or stock market index.
The Capital Asset Pricing Model (CAPM) provides a linear relationship between the required rate of return (Ri) of a security and its Systematic or undiversifiable risk as measured by the security’s beta. The systematic risk of a security, which is measured by the beta coefficient of the security, is the market risk that cannot be eliminated through diversification. According to Capital Asset Pricing Model approach, the required return on a security is given by the equation:
Ri = Rf + βi ( Rm – Rf )
- Ri = Required rate of return on security i or cost of equity.
- Rf = Risk-free rate of return.
- βi = Beta of security i.
- Rm = Rate of return on market portfolio.
The graphical plot of the relationship between the required rate of return (ke) and the nondiversifiable risk (beta) of security is known as Security Market Line (SML).
Under equilibrium conditions, any individual securities expected return and beta should lie on the SML. Since all securities are expected to plot along the SML, the line provides a direct way of determining the expected (required) return of a security once the beta of the security is known.