Final answer:
The systematic risk principle relates expected returns to systematic risk—the risk impacting the entire market or economy that cannot be avoided through diversification. The expected rate of return defines anticipated earnings, while the actual rate of return includes the total gains realized over a period.
Step-by-step explanation:
The systematic risk principle states that the expected return on a risky asset depends only on the asset's systematic risk. Systematic risk, often referred to as market risk, is the part of an investment's risk that is attributable to broad economic factors and cannot be eliminated through diversification. It reflects the impact of macroeconomic factors that affect all assets, such as changes in fiscal policy, inflation rates, exchange rates, and geopolitical events.
The expected rate of return is what investors anticipate earning on an investment, factoring in future interest payments, capital gains, or increased profitability, expressed as a percentage over a given time frame. Risk is associated with the uncertainty surrounding these returns, which comes in various forms like default risk or interest rate risk. A high-risk investment has a broad range of potential outcomes, while a low-risk investment typically sees actual returns hovering near its expected rate of return more consistently. Actual rate of return refers to the total rate of return on an investment after a specified period, encompassing capital gains and interest received.