Understanding CAPM: How a Stock's Beta Influences Price Changes

If a stock has a beta of 1.4 and the market decreases by 10%, what is the expected change in the stock's price according to CAPM?

• A. Be down 10%
• B. Be down 14%
• C. Be up 10%
• D. Be unchanged

Answer: (B)

To determine the expected change in a stock's price using the Capital Asset Pricing Model (CAPM), we need to understand the concept of beta. Beta is a measure of a stock's volatility in relation to the overall market. A beta of 1.4 indicates that the stock is expected to be 40% more volatile than the market. In this scenario, if the market decreases by 10%, we can calculate the expected change in the stock's price by multiplying the market's change by the stock's beta. Specifically, you would take the negative change in the market (which is -10%) and multiply it by the beta value of 1.4. The calculation is as follows: Expected change in stock price = Beta × Change in market Expected change in stock price = 1.4 × (-10%) Expected change in stock price = -14% This means the stock is expected to decrease by 14% as a result of the 10% decrease in the market, reflecting its higher sensitivity to market movements due to its beta being greater than 1. Thus, the answer indicating the stock will be down 14% captures the relationship between market changes and the expected movement in this particular stock's price accurately.

When studying for the Certified Valuation Analyst (CVA) exam, it’s crucial to grasp key concepts like the Capital Asset Pricing Model (CAPM) and the importance of beta. Ever wondered how market movements affect individual stock prices? Well, let's break it down. In the world of finance, we often hear the term "beta" thrown around—it's a powerful indicator of a stock's volatility relative to the market.

So, what does a beta of 1.4 actually mean? In simpler terms, it suggests that the stock is typically 40% more volatile than the broader market. Now, if the market takes a dive, say by 10%, you might be wondering how this impacts that stock with a beta of 1.4. Let’s think about this in practical terms. Picture yourself riding a wave on a surfboard. If the ocean (our market) swells in size or surges forward, your ride (the stock) will likely wobble and react even more forcefully.

Now, let's get into the math of it! To estimate how much that stock will plunge, you would multiply the change in the market by the stock’s beta. For our example, the calculation is straightforward:

Expected change in stock price = Beta × Change in market

Expected change in stock price = 1.4 × (-10%)

Expected change in stock price = -14%

So, in this scenario, the stock is expected to drop by a whopping 14%. Ouch! What does that really tell you? It reflects how sensitive the stock is to market fluctuations. When the market drops, this elevated beta indicates that the stock will suffer even more.

That’s a critical takeaway for aspiring CVA candidates! Understanding how different stocks respond to market shifts can help you make informed decisions when advising clients or investing yourself. Have you noticed any other stocks with a similar kind of beta rating? It could be eye-opening to track their movements and see how closely they follow the expected outcomes calculated through CAPM.

Ultimately, the relationship between beta and market movements is vital for anyone considering the nuanced world of valuation and financial analysis. As you prepare for the exam, keep these concepts at the forefront of your studies. Your understanding of these dynamics not only sharpens your skills but also enhances your ability to provide insightful guidance!