Question

Define beta, what it measures, how to interpret beta, and how beta is used as part of the capital asset pricing model. Discuss the advantages and disadvantages to using beta.

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Answer 1

Beta is sensitivity of the movement of the Asset in respect to the market and it will be reflecting the volatility of the Asset.

Beta will be measuring the systematic risk associated with the Asset and it is also representing the volatility of the asset in respect to the market.

Bata can be interpreted as when the beta of the stock will be higher than 1, it will mean that stock is more volatile than the entire market and when the beta of a stock is lower than one, it will mean that it is a defensive stock and it is having a lower volatility in respect to the market.

Beta is used in Capital Asset pricing model to represent the systematic risk and beta will be representing the overall systematic risk associated with investment of an asset in Capital Asset pricing model and there will be a direct relationship between beta and the rate of return because when there will be a higher bata of a stock from there will be higher rate of return which will be demanded by the investor because of higher systematic risk and vice versa.

Advantages of using the beta is that it will be helpful in understanding the volatility of the stock and it will also help in understanding the expected rate of return in the market and it will also be reflecting upon the risk maintenance of the portfolio. Beta is also used for creation of various strategies which will be used for Risk reduction.

Disadvantages related to use of Beta is that beta is never constant and it is changing always and beta is used on historical basis which is not appropriate and beta will not be reflecting the complete systematic risk of the market as the portfolio are not completely diversified.