1. Which of the following is NOT a potential problem when estimating and using b

Question

1.        Which of the following is NOTa potential problem when estimating and using betas, i.e., which statement is FALSE?

a.        Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta.

b.       The beta of an "average stock," or "the market," can change over time, sometimes drastically.

c.        Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.

d.       All of the statements above are true.

e.        The fact that a security or project may not have a past history that can be used as the basis for calculating beta.

Explanation / Answer

Answer: Option B i.e. The beta of an "average stock," or "themarket," can change over time, sometimes drastically.

Reason:

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta less than 1 means that the security will be less volatile than the market. A beta greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2 it's theoretically 20% more volatile than the market.

Many utilities stocks have a beta of less than 1. Conversely most high-tech Nasdaq-based stocks have a beta greater than 1, offering the possibility of a higher rate of return but also posing more risk.

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