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:
Calculating systematic variance for each security:
Analysis:
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)
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An analyst gathers the following information about three securities:
| Security | Total Variance of Returns | Nonsystematic Variance of Returns |
|---|---|---|
| Security 1 | 0.20 | 0.05 |
| Security 2 | 0.30 | 0.25 |
| Security 3 | 0.35 | 0.22 |
According to capital market theory, which security has the highest expected return?
A
Security 1.
B
Security 2.
C
Security 3.
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