180 Financial Management the standard deviation to compare the riskiness of two projects can be misleading when dealing with a scale size problem. If Project A and B had the following means and standard deviations, it would be difficult to say which has the greater attractiveness, Project a B Mean © 35,000 Rs25,000 Standard Deviation 3,000 2,000 Project A has a higher risk, but it also has a higher mean than Project B. If we compute the coefficient of variation, we would see that: which implies that Project B has less risk per & of expected return than Project A. This comparison is only possible when we use the coefficient of variation. IDENTIFYING THE RELEVANT RISK Total variability of returns is not the relevant risk measure for a security. The risk of each security (or of a portfolio) can be decomposed into two parts. The first component is that part of a security's risk which can be eliminated by combining it ina diversified portfolio. This diversifiable component of risk is often called the non- systematic risk, since no systematic relationship exists between this portion of the risk and the market. The non diversifiable component of a security’ risk, ie. the part of the risk of its returns which can not be eliminated by including the security in a diversified portfolio, is usually called the systematic risk. The latter stems from the general market fluctuations or more specifically from the component of a security’s risk which reflects the relationship of its fluctuations to those of the market portfolio, Itis this nondiversifiable portion of the risk which gives rise to the risk premium; the non systematic risk requires no such premium since it can be eliminated through diversification. The higher a security's beta (other things being constant), the higher is the non-diversifiable risk, and therefore the higher is the expected return on this security. The effect of diversification on the risk of a security can be represented graphically. Figure-8 shows that the increase in the randomly selected securities in the portfolio reduces the total risk. CAPITAL ASSET PRICING MODEL Capital Asset Pricing Model (CAPM) relates the risk-return trade-off of individual assets to market returns. An analyst's view of the relationship between a security's prospects and those of the market portfolio can be summarised by means of a characteristic line Figure-9 shows an example. The vertical axis plots the excess return on the security in question. This is the differences between the holding period return on the security and the riskless rate of interest for that period. In symbols: R=T+B(R,-T)