If the simple CAPM (Capital Asset Pricing Model) is valid, which of the following statements is true?

• A. The expected return on a security is determined solely by its beta with respect to the market portfolio.
• B. Diversifiable risk is compensated with higher expected returns.
• C. All investors will hold different portfolios based on their individual risk preferences.
• D. The risk-free rate is always equal to the expected return on the market portfolio.

Answer: (A)

Verified step by step guidance

1. Recall the Capital Asset Pricing Model (CAPM) formula for the expected return on a security: \[\text{E}(R_i) = R_f + \beta_i \left( \text{E}(R_m) - R_f \right)\] where \(\text{E}(R_i)\) is the expected return on security \(i\), \(R_f\) is the risk-free rate, \(\beta_i\) is the beta of security \(i\) relative to the market portfolio, and \(\text{E}(R_m)\) is the expected return on the market portfolio.
2. Understand that in CAPM, the expected return depends only on the security's beta, which measures its systematic risk relative to the market. This means that only non-diversifiable (systematic) risk is rewarded with higher expected returns.
3. Recognize that diversifiable risk (also called idiosyncratic or unsystematic risk) can be eliminated through diversification and therefore does not affect the expected return according to CAPM.
4. Note that CAPM assumes all investors hold the market portfolio combined with the risk-free asset, adjusted for their risk preferences, so they do not hold different portfolios based on individual risk preferences alone.
5. Remember that the risk-free rate is distinct from the expected return on the market portfolio; the risk-free rate is typically lower and represents a return with zero risk, while the market portfolio has higher expected return due to bearing systematic risk.