Beta is calculated by a specific formula that helps determine a security's volatility in relation to the overall market. In essence, it quantifies how much a stock's price tends to move when the market moves.
Here's the breakdown of the calculation based on the provided reference:
Beta is calculated by dividing the product of the covariance of the security's returns and the market's returns by the variance of the market's returns over a specified period. The calculation helps investors understand whether a stock moves in the same direction as the rest of the market.
In simpler terms:
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Covariance: Measures how two variables (security returns and market returns) change together. A positive covariance means they tend to move in the same direction, while a negative covariance means they tend to move in opposite directions.
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Variance: Measures how much the market's returns deviate from its average return. It's a measure of the market's overall volatility.
The formula can be represented as:
Beta = Covariance(Security Returns, Market Returns) / Variance(Market Returns)This calculation essentially normalizes the relationship between the security and the market, allowing investors to gauge the security's systematic risk (risk that cannot be diversified away). A beta of 1 indicates that the security's price tends to move with the market. A beta greater than 1 indicates that the security is more volatile than the market, and a beta less than 1 indicates that the security is less volatile than the market. A negative beta means the security moves in the opposite direction of the market.
