If investors hold the market portfolio of risky assets, the expected returns on individual assets are determined solely by the risk-free rate, the premium one would expect by investing in the market portfolio, and the risk of the specific investment relative to the market portfolio.
The risk remaining in the market portfolio reflects the correlation or covariance of the security with the market portfolio and is called the beta. The beta risk indicates how sensitive the security is to movements in the market portfolio. Beta risk is rewarded in that an investor can expect to earn a greater return the more of this risk accepted. Diversifiable risk is not rewarded because it can be completely eliminated. That is, you cannot expect to earn a higher return for accepting diversifiable risk.
The model that gives us this relationship is called the Capital Asset Pricing Model or CAPM. Most people believe that this model is not a completely accurate picture of what happens in the market but that it is approximately correct and useful enough for companies to apply.
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Last updated: January 9, 2011