theory of asset pricing used to analyze the relationship between risk and rates of return in securities. The return of an asset or security is the risk-free return plus a risk premium based on the excess of the return on the market over the risk-free rate multiplied by the asset's systematic risk (which cannot be eliminated by diversification). The model is given as follows:

r = rf + b ( rm - rf )

where r = the expected (or required) return on a security, rf = the risk-free rate (such as a T-bill), rm = the expected return on the market portfolio (such as Standard & Poor's 500 Stock Composite Index or Dow Jones 30 Industrials), and b = beta, an index of systematic (nondiversifiable, uncontrollable) risk. For example, assume that the risk-free rate (rf ) is 8%, and the expected market return (rm ) is 12%.

Then if b = 0, r = 8% + 0 (12% 8%) = 8%. If b = 2.0, r = 8% + 2.0 (12% 8%) = 16%. This shows that the higher the degree of systematic risk (b), the higher the return on a given security demanded by investors.