Question

1. Explain how we assess the risk of a stock. Include in your response the role that the Security Market Line plays in risk assessment.

2. Explain the usefulness of the Security Market Line in assessing common stock risk. Explain how we use bond rating categories to assess bond risk

Answer 1

1). Risk is a form of uncertainty. Risk of an Individual stock can be assess by three measures. These are as follows:-

1. Standard Deviation ($\sigma$)
2. Variance ($\sigma^{2}$)
3. Coefficient of variation (CV)

Security Market Line is the representation of the capital asset pricing model by which we find out expected return of an individual security. Security Market line shows the relationship between Systematic Risk and Expected Return. Systematic Risk of a stock is known as Beta ($\beta$).

Every stock have two type of risk i.e Systematic Risk and Unsystematic risk. Standard Deviation ($\sigma$) is the sum of Systematic Risk and Unsystematic Risk .Security Market Line focuses on systematic risk of a security.

So, we can say that Security Market line play a crucial role in risk assessment.

2) Usefulness of the Security Market Line in assessing common stock risk are as follows:-

1. Security Market Line is used in comparing two similar stocks offering approximately the same return, in order to determine which of the two stocks involves the least amount of inherent market risk in relation to the expected return.
2. Security Market Line can also be used to compare stocks of equal risk to see which one offers the highest expected return against that level of risk.

Security Market Line can be a valuable tool in equity evaluation and comparison but still it should not be used in segregating various stock for investment choices, because the expected return of an investment over the risk-free rate of return is not the sole consideration when making investment choices.

In investment, the bond credit rating represents the credit worthiness of corporate or government bonds.

The ratings are published by credit rating agencies and we use these ratings to assess credit worthiness of Bonds issuing company for knowing that Bond issuing company has capacity to repay the debt or not ?

Bond rating is decided by the past track records of the company.

Hence, we can say that Bond Rating is useful to assess bond risk.