Question

A stock’s contribution to the market risk of a well-diversified portfolio is called risk. It can be measured by a metric called the beta coefficient, which calculates the degree to which a stock moves with the movements in the market. Based on your understanding of the beta coefficient, indicate whether each statement in the following table is true or false: Statement True False Beta coefficients are generally calculated using historical data. Higher-beta stocks are expected to have higher required returns. Stock A’s beta is 1.0; this means that the stock has a negative correlation with the market.

Answer 1

Higher-beta stock are expected to have higher required returns.

Why? → The broad equity market has a Beta of 1, beta coefficient of different stocks are measures with reference to the market beta.

If a beta coefficient is below 1, this means that the stock has a systematic risk which is lower that the market risk. When the beta coefficient is greater than 1 it means that the stock has an above-average risk and for that reason it has to have a greater return (since when you have more risk, you have to ask for more return in exchange of it)

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Beta coefficient is calculated by dividing the covariance of a stock´s return with market returns by variance of market return.

If beta is equal to 1, it means that the stock has a equal correlation with the market (its beta has to be less than 1 for the correlation to be negative)

Answer 2

The correct answers are:

1) True

2) True

3) False

Step-by-step explanation:

The Beta Coefficient measures the volatility of a stock compared to the overall market movements. Using the stock historical price movement, Beta is graphically portrait on a slope where "0" means that the stock does not follow the overall market price movements, "-1" implies negative correlation which is the stock not moving in the same market direction, and "1" when the stock is highly correlated with the market price movement thus higher returns are expected.

1) Beta coefficients are generally calculated using historical data. True.

2) Higher-beta stocks are expected to have higher required returns. True.

3) Stock A’s beta is 1.0; this means that the stock has a negative correlation with the market. False.