A measure that describes the risk of an investment project relative to other investments in general is known as the “beta.” Beta is a key financial metric used in investment analysis, particularly in the context of the Capital Asset Pricing Model (CAPM). It quantifies the systematic risk or volatility of an investment compared to the overall market. Question: What does beta measure in the context of investment analysis? A. Specific risk of an investment B. Volatility of an investment relative to the overall market C. Total risk associated with an investment D. Liquidity of an investment
The correct answer and explanation is:
The correct answer is B. Volatility of an investment relative to the overall market.
In investment analysis, beta is a key metric that measures the systematic risk of an asset or investment in relation to the market as a whole. It specifically quantifies how much an investment’s returns move in relation to the broader market, typically represented by a market index like the S&P 500.
Beta is used in the Capital Asset Pricing Model (CAPM) to help estimate the expected return of an asset based on its relationship with the market. If a stock has a beta of 1, it means the investment’s price tends to move in line with the market. A beta greater than 1 suggests that the investment is more volatile than the overall market, meaning its price fluctuations are greater in magnitude. Conversely, a beta less than 1 indicates that the asset is less volatile and tends to experience smaller price movements compared to the broader market.
For example, if a stock has a beta of 1.5, it means that for every 1% change in the market’s return, the stock’s return is expected to change by 1.5%. This reflects higher risk and potential for greater reward or loss, depending on the market direction. Beta is particularly important for investors who want to understand the level of risk they are taking relative to market movements, as it helps them make decisions about portfolio diversification and risk management.
In summary, beta measures an investment’s sensitivity to overall market fluctuations and is crucial for assessing how much market risk an investor is exposed to. It helps to gauge an asset’s potential volatility in comparison to the broader market, making it a valuable tool for managing risk in a portfolio.