Question

What is measured by a stock’s “beta”? Suppose that stock A has a higher beta than stock B, but its rate of return has a lower standard deviation than that of stock B. According to the CAPM, which stock should be expected to offer a higher average rate of return? Explain.

Answer 1

Beta is a measure used in fundamental analysis to determine the volatility of an asset or portfolio in relation to the overall market. The overall market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market.

What Is Beta?

A stock that swings more than the market over time has a beta greater than 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks tend to be riskier but provide the potential for higher returns; low-beta stocks pose less risk but typically yield lower returns.

As a result, beta is often used as a risk-reward measure meaning it helps investors determine how much risk their willing to take to achieve the return for taking on that risk. A stock's price variability is important to consider when assessing risk. If you think of risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.

How to Calculate Beta

To calculate the beta of a security, the covariance between the return of the security and the return of the market must be known, as well as the variance of the market returns.

Beta=VarianceCovariance​where:Covariance=Measure of a stock’s return relativeto that of the marketVariance=Measure of how the market moves relative to its mean​.

According to CAPM, the greater the beta – hence, the risk – the higher the expected rate of return. Since A has a higher systematic risk – beta – it should have a higher expected return. Note, the only factor that differentiates one asset’s expected rate of return from another is Beta. Consider the implications of this notion ---- nothing else matters (e.g., charts of price and volume movements, the fundamentals of the issuer, etc.)