A:

A. the covariance between the stock and the market.

B. the variance of the market.

C. the market risk premium.

D. the stock's correlation with the other securities in the portfolio.


The general idea behind capital asset pricing model (CAPM) is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Beta is the the covariance between the stock and the market divided by the variance of the market.

Correct answer: D. the stock's correlation with the other securities in the portfolio.

RELATED FAQS
  1. What is the difference between variance and covariance?

    Learn more about the differences between covariance and variance, and how these metrics can be of use to you in minimizing ... Read Answer >>
  2. How can I measure portfolio variance?

    Find out more about portfolio variance, the formula to calculate portfolio variance and how to calculate the variance of ... Read Answer >>
  3. What is the formula for calculating the capital asset pricing model (CAPM)?

    Learn about the capital asset pricing model, or CAPM, and how this formula is used to determine the expected rate of return ... Read Answer >>
  4. How do you interpret the magnitude of the covariance between two variables?

    Learn more about covariance and how financial planners and economists use the concept. Explore an example of covariance in ... Read Answer >>
  5. What types of assets lower portfolio variance?

    Learn what type of assets reduce portfolio variance and how modern portfolio theory uses correlation coefficients. Read Answer >>
  6. What is the difference between expected return and variance?

    Learn about expected return and variance, the difference between the two measures and how to calculate the expected return ... Read Answer >>
Related Articles
  1. Investing

    Calculating Portfolio Variance

    Portfolio variance is a measure of a portfolio’s volatility, and is a function of two variables.
  2. Investing

    The Capital Asset Pricing Model: an Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  3. Investing

    What is Covariance?

    Covariance is a concept used in statistics and probability theory to describe how two variables change when compared to one another. In business and investing, covariance is used to determine ...
  4. Investing

    The Capital Asset Pricing (CAPM) Model: Pros and Cons

    CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
  5. Investing

    Explaining Variance

    Variance is a measurement of the spread between numbers in a data set.
  6. Investing

    Introduction To International CAPM

    ICAPM is one of several models used to determine the required return on an asset, discover its limitations and how to use it.
  7. Investing

    Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.
  8. Investing

    Is the Stock Correlation Strategy Effective?

    The synchronized movement among stocks and markets in recent years is challenging diversification.
RELATED TERMS
  1. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected ...
  2. Portfolio Variance

    The measurement of how the actual returns of a group of securities ...
  3. International Capital Asset Pricing Model (CAPM)

    A financial model that extends the concept of the capital asset ...
  4. Covariance

    A measure of the degree to which returns on two risky assets ...
  5. Market Risk Premium

    The difference between the expected return on a market portfolio ...
  6. Roll's Critique

    An economic idea that suggests that it is impossible to create ...
Hot Definitions
  1. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  2. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
  3. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  4. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  5. Risk Averse

    A description of an investor who, when faced with two investments with a similar expected return (but different risks), will ...
  6. Indirect Tax

    A tax that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An ...
Trading Center