Explanation

According to the Capital Asset Pricing Model (CAPM), the priced risk of an individual security is its systematic risk (also known as market risk or non-diversifiable risk), which is measured by beta (β).

Let's analyze each option:

Option A: measured by the security's standard deviation of returns.

• This is incorrect. Standard deviation measures total risk (both systematic and unsystematic risk). CAPM specifically states that only systematic risk is priced.

Option B: determined primarily by the security's nonsystematic risk.

• This is incorrect. Nonsystematic risk (also called idiosyncratic or diversifiable risk) is not priced according to CAPM because it can be eliminated through diversification.

Option C: affected by holding the security in a well-diversified portfolio.

• This is correct. In a well-diversified portfolio, nonsystematic risk is eliminated, leaving only systematic risk. The security's contribution to portfolio risk (its systematic risk) is what gets priced in the market.

Key CAPM Concepts:

1. Systematic Risk (Market Risk): Risk that affects all securities in the market, measured by beta (β).
2. Unsystematic Risk (Specific Risk): Risk unique to individual securities, which can be diversified away.
3. Beta (β): Measures a security's sensitivity to market movements. β = 1 means the security moves with the market; β > 1 means more volatile than the market; β < 1 means less volatile.
4. Security Market Line (SML): Shows the relationship between expected return and systematic risk (β).

According to CAPM, investors are only compensated for bearing systematic risk because unsystematic risk can be eliminated through diversification. Therefore, the priced risk of an individual security is its contribution to portfolio risk in a well-diversified portfolio, which is its systematic risk component.