Financial Risk Manager Part 1

Explanation

The beta coefficient in the Capital Asset Pricing Model (CAPM) measures the sensitivity of a stock's returns to changes in the market returns.

• A beta of 1 indicates that the stock's price will move with the market
• A beta less than 1 indicates that the stock will be less volatile than the market
• A beta greater than 1 indicates that the stock will be more volatile than the market

In this case, a beta of 2 means that the stock is expected to return twice the market's excess return over the risk-free rate. Therefore, for every percentage point performance attained by the market over above the risk-free rate, we would expect the stock to achieve 2 percentage points extra return.

Why other options are incorrect:

• Choice A: A beta value of 2 indicates that the stock's return is expected to change by 2 percentage points for every percentage point change in the market, not just 1 percentage point.
• Choice C: The beta value does not indicate a lower return but rather a higher sensitivity to market movements. A beta of 2 suggests that the stock's return would increase or decrease by twice as much as any given market movement.
• Choice D: The CAPM model and its use of beta provide a clear method for estimating expected returns based on market performance and risk relative to the market, making it possible to determine an expected response.