Financial Risk Manager Part 1

The Capital Asset Pricing Model (CAPM) is the most appropriate measure for calculating the expected return of individual securities. The CAPM is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. CAPM is a more comprehensive measure as it considers the risk-free rate, the beta of the security, and the expected market return.

Choice A is incorrect. The Sharpe ratio is a measure of risk-adjusted return, not a measure for determining the expected return of individual securities within a portfolio. It is used to understand the portfolio's performance by adjusting for its risk.

Choice B is incorrect. The Capital Market Line (CML) represents portfolios that optimally combine risk and return. CML is used in the capital asset pricing model to depict rates of return for efficient portfolios depending on the risk-free rate of interest and levels of risk (standard deviation). However, it does not directly determine the expected returns of individual securities.

Choice D is incorrect. Beta measures a security's sensitivity to market movements and can be used as part of CAPM to calculate expected returns, but Beta itself does not provide an estimate for expected returns.