Capital Asset Pricing Model estimates the expected return of an asset based on

• A. Risk-free rate only
• B. Market return only
• C. Beta only
• D. Risk-free rate, market return, and beta

Answer: (D)

CAPM states that the expected return on an asset is determined by three elements: the baseline time value of money captured by the risk-free rate, the overall market's expected return that represents the risk premium, and the asset's sensitivity to market moves measured by beta. In formula form, E[R_i] = R_f + beta_i × (E[R_m] − R_f). The term (E[R_m] − R_f) is the market risk premium, i.e., the extra compensation investors demand for taking on systematic risk. Beta scales that premium to reflect how much the asset tends to move with the market; a higher beta means a larger expected return, a beta of zero yields the risk-free rate, and a negative beta would imply a different risk profile. Because CAPM uses all three components, this option is the best fit. Other options omit one or more of these essential pieces, so they can't fully capture how CAPM computes expected return.