The Capital Asset Pricing Model (CAPM) relates the required rate of return on a security to what?

The Capital Asset Pricing Model (CAPM) is fundamentally based on the principle that the expected return on a security is directly related to its systematic risk, which is quantified by a measure known as beta. Beta reflects the sensitivity of a security's returns to the movements in the overall market.

In the context of CAPM, the equation used is:

Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).

This equation illustrates how a security's expected return is influenced by market risk (systematic risk) rather than idiosyncratic risk, which is specific to individual securities or companies and can be diversified away in a well-structured portfolio.

By using beta, CAPM helps investors understand that a higher level of systematic risk should yield a higher expected return. Therefore, the correct answer conveys the essential link between the required rate of return and the level of systematic risk as represented by beta, making it a foundational concept in risk and return analysis in finance.