For each 1% change in the market portfolio’s excess return, the investment’s excess return is expected to change by __ due to risks that it has in common with the market.
A Beta
B Sigma
C 0%
D 1%
The correct answer and explanation is:
The correct answer is A. Beta.
Explanation:
Beta is a measure of an investment’s sensitivity to overall market movements. It quantifies the degree to which the investment’s excess return is expected to change in response to a 1% change in the market portfolio’s excess return. Essentially, Beta represents the systematic risk, or the risk that cannot be diversified away, that an investment shares with the broader market.
If a stock has a Beta of 1, for example, it is expected to move in perfect correlation with the market. This means that for every 1% change in the market portfolio’s excess return, the stock’s excess return will also change by 1%. If Beta is greater than 1, the stock is considered more volatile than the market, meaning it will experience greater changes in return than the market. If Beta is less than 1, the stock is less volatile, and its returns will change less than the market’s.
Beta is calculated using historical data, which measures the covariance between the asset’s returns and the market’s returns, divided by the variance of the market’s returns. This statistic helps investors understand how much of an asset’s performance is driven by market-wide factors, and it is a key input in the Capital Asset Pricing Model (CAPM), which helps determine the expected return on an investment given its risk relative to the market.
In contrast, Sigma refers to the standard deviation of an asset’s return, which measures the total risk, both systematic and unsystematic, and is not directly related to the market portfolio’s excess return. Therefore, Beta is the correct choice in this scenario, as it specifically addresses the relationship between an asset’s return and the market’s return.