Within the context of the capital asset pricing model (CAPM), the risk measure known as beta is often computed by regressing thereturn of the company’s stock against the
(A) change in the consumer price index
(B) change in the gross domestic product
C return on the market portfolio
D return on the company’s bonds
The correct answer and explanation is:
The correct answer is C) return on the market portfolio.
Explanation:
In the context of the Capital Asset Pricing Model (CAPM), beta (β) is a measure of a stock’s volatility or risk in relation to the overall market. It quantifies how much the stock’s return moves in relation to the return of the market portfolio, which is a diversified portfolio of all available risky assets in the market. The formula for CAPM is: Ri=Rf+βi(Rm−Rf)R_i = R_f + \beta_i (R_m – R_f)
where:
- RiR_i is the expected return of the individual stock,
- RfR_f is the risk-free rate,
- RmR_m is the expected return of the market portfolio,
- βi\beta_i is the beta of the stock.
Beta is computed by running a regression of the stock’s return against the return on the market portfolio (often represented by a broad index like the S&P 500). In this regression, the stock’s return is the dependent variable, and the return on the market is the independent variable. The slope of the regression line represents the beta coefficient, which measures the stock’s sensitivity to changes in the market return.
A beta greater than 1 means the stock is more volatile than the market, while a beta less than 1 indicates the stock is less volatile. A beta of 1 indicates the stock’s price moves in line with the market. The CAPM assumes that investors are rational and that the market portfolio is efficient, meaning that it contains all risky assets and provides the optimal risk-return tradeoff.
Using the return on the market portfolio is key because it represents the broad market’s risk and return, which is a benchmark for evaluating the relative risk of individual assets.