Answer: systematic risk only.

## Explanation According to the Capital Asset Pricing Model (CAPM), the expected return of a security is determined by its systematic risk (beta), not its total risk or nonsystematic risk. ### Key Concepts: 1. **CAPM Formula**: E(Ri) = Rf + βi[E(Rm) - Rf] - E(Ri) = Expected return of security i - Rf = Risk-free rate - βi = Beta of security i (measure of systematic risk) - E(Rm) = Expected market return 2. **Systematic vs. Nonsystematic Risk**: - **Systematic risk** (market risk) affects all securities and cannot be diversified away - **Nonsystematic risk** (specific risk) is unique to individual securities and can be eliminated through diversification 3. **Why Option B is Correct**: - CAPM assumes investors hold well-diversified portfolios, eliminating nonsystematic risk - Only systematic risk (beta) is priced in the market - The difference in expected returns between two securities is proportional to the difference in their betas 4. **Why Other Options are Incorrect**: - **Option A (total risk)**: Includes both systematic and nonsystematic risk, but CAPM only prices systematic risk - **Option C (nonsystematic risk only)**: This risk can be diversified away and is not rewarded in CAPM ### Example: If Security A has β = 1.2 and Security B has β = 0.8, and the market risk premium is 5%: - E(RA) - E(RB) = (1.2 - 0.8) × 5% = 0.4 × 5% = 2% The 2% difference is determined solely by the difference in systematic risk (beta).

Author: LeetQuiz .