Which of the following best describes the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is fundamentally a financial model that evaluates the relationship between the risk of an asset and its expected return. This model helps investors understand how much additional return they can expect for taking on additional risk.

CAPM incorporates two key components: the risk-free rate, which reflects the return on an investment with zero risk typically represented by government bonds, and the equity risk premium, which compensates an investor for taking on the risk associated with investing in a particular asset or the market as a whole. The model is mathematically expressed with the formula: Expected Return = Risk-Free Rate + Beta (Market Return - Risk-Free Rate), where Beta measures the sensitivity of the asset's returns to market movements.

This understanding of the risk-return relationship makes CAPM particularly valuable for making informed investment decisions, comparing the expected returns on investments with their inherent risks, and helping in portfolio management. As a result, it clearly aligns with the characterization of a model that assesses stock risk and return, distinguishing it from other financial concepts that focus on taxation, asset valuation, or budgeting.