Question

According to CAPM Beta can have many definitions. Please mark the only CORRECT one:

	a.	If the covariance between stock B and the market is 200 and the volatility of the market index is 20%, then B’s Beta will be 0.5
	b.	The higher the covariance between stock A and the market, the lower its Beta
	c.	Beta measures the volatility of the stock
	d.	Given a collection of 10 stocks, the one with the highest covariance with the market portfolio will be the one with the lowest variance

Answer 1

The correct options are (a) and (c).

a) The beta of a stock is used as a measure of systematic risk or volatility of an asset or portfolio in relation to the overall market.

The beta of a stock may be calculated as follows:

Beta = Covariance/Variance,

where,

Covariance= Measure of a stock’s return in relation to the market

Variance= Measure of market variance in relation to its mean​

=> (200)/(20)^2 = 200/400 = 0.5

c) Beta measures the volatility of a security or portfolio, in relation to the market. By knowing the beta values, the investor can get a fair idea of the level of risk the stock will add to the portfolio.

Options b) and d) are not correct.

Covariance is a measure of how two stocks move together. A positive covariance means the stocks tend to move in the same direction, when their prices go up or down. A negative covariance means the stocks move in opposite directions.

For the various stocks in a portfolio, there may be varying levels of covariance with other stocks as well as variance.