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.

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