Business Degree Certification Practice Test

In the context of the capital asset pricing model (CAPM), how is the risk measure known as beta typically computed?

1. By regressing the return of the company's bonds

2. By regressing the return on the market portfolio

3. By regressing the change in the gross domestic product

4. By regressing the change in the consumer price index

The correct answer is: By regressing the return on the market portfolio

In the context of the capital asset pricing model (CAPM), beta is a measure of a stock's volatility in relation to the overall market. It is computed by regressing the return on the stock against the return on the market portfolio. This statistical method assesses how much the stock's returns move in relation to the market's returns, thus determining the stock's systemic risk. Using regression analysis in this manner allows for capturing the relationship between the stock and the market, leading to a quantifiable beta value. A beta greater than 1 indicates that the stock is more volatile than the market, while a beta of less than 1 suggests it is less volatile. This relationship is central to making investment decisions, as it assists investors in understanding how market movements could influence the performance of a specific asset. The other options involve measures that do not directly relate to calculating beta in the context of CAPM. For instance, regressing the return of the company's bonds or changes in economic indicators like GDP or the consumer price index does not yield the necessary insight into a stock's relative risk compared to the market, which is essential for properly determining its beta value. Hence, the correct method for calculating beta is by regressing the stock's returns against the returns on the