What does CAPM predict about the relationship between beta and expected return?

The Capital Asset Pricing Model (CAPM) establishes a crucial relationship between the risk of an asset, as measured by its beta, and the expected return on that asset. Beta quantifies the sensitivity of an asset's returns to market returns—the higher the beta, the more volatile the asset relative to the market.

According to CAPM, a higher beta indicates greater risk, which investors typically demand compensation for in the form of higher expected returns. This principle reflects the risk-return tradeoff, where investors are willing to accept lower returns for less risky investments and higher returns for riskier ones. The formula for CAPM is expressed as:

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

In this formula, an increase in beta directly increases the expected return. Therefore, it is this direct correlation—higher beta leading to higher expected returns—that is accurately represented in the model, hence supporting the selection of that answer as the correct one.