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).