Answer: Security 1.

## Explanation According to Capital Market Theory (specifically 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. **Total Variance** = Systematic Variance + Nonsystematic Variance 2. **Systematic Variance** = Total Variance - Nonsystematic Variance 3. **Expected Return** is proportional to systematic risk (beta), which is related to systematic variance **Calculating systematic variance for each security:** - Security 1: Systematic Variance = 0.20 - 0.05 = 0.15 - Security 2: Systematic Variance = 0.30 - 0.25 = 0.05 - Security 3: Systematic Variance = 0.35 - 0.22 = 0.13 **Analysis:** - Security 1 has the highest systematic variance (0.15) - Security 2 has the lowest systematic variance (0.05) - Security 3 has moderate systematic variance (0.13) Since expected return is directly proportional to systematic risk, and Security 1 has the highest systematic variance, it should have the highest expected return according to capital market theory. **Why not Security 3?** While Security 3 has higher total variance (0.35), most of it is nonsystematic risk (0.22), which can be diversified away in a well-diversified portfolio. Only systematic risk is rewarded in the market. **Answer: A (Security 1)**

Author: LeetQuiz .