How to Answer “What is beta and how is it used in CAPM?” in Investment Banking Interviews

Start with a crisp definition and one sentence of intuition.

• Definition: Beta measures how much an asset’s returns tend to move relative to the market (typically an index), i.e., its systematic risk.
• Interpretation: A beta of 1.0 means it tends to move in line with the market; >1.0 means more sensitive (higher systematic risk); <1.0 means less sensitive; negative means it tends to move opposite the market (rare for operating companies).

Add one clarifier interviewers like to hear: beta is about covariance with the market, not idiosyncratic risk, because in diversified portfolios idiosyncratic risk can be diversified away. This sets you up to explain why CAPM uses beta specifically.

Deliver the CAPM equation and translate it into words.

• CAPM: (R_e = R_f + \beta \times (R_m - R_f))
  • (R_e): required return / cost of equity
  • (R_f): risk-free rate
  • (R_m - R_f): equity risk premium (market risk premium)

Explain the role of beta: it is the multiplier on the market risk premium, scaling the extra return investors demand for taking market risk. Then connect it to investment banking usage: cost of equity feeds into WACC, which is used to discount free cash flows in a DCF, and it can also be used as a required return hurdle when thinking about equity investors’ expectations.

In a CAPM explanation for interviews, this is where you show you can move from theory to inputs.

• Observed/“raw” beta is typically estimated by regressing a stock’s returns against market returns over a chosen horizon and frequency (e.g., 2–5 years of weekly returns). The result depends on choices: index, time window, frequency, and statistical noise.
• Many practitioners use adjusted beta (e.g., Blume-style mean reversion) because raw betas can be noisy and tend to revert toward 1 over time.

Mention key pitfalls succinctly: thin trading, regime shifts, major business mix changes, and using an index that doesn’t match the investor base. The interviewer wants to hear that beta is an estimate, not a constant handed down from a textbook.

This is often the differentiator in CAPM investment banking questions.

Explain that equity beta reflects both business risk and financial leverage. To estimate a beta for a target capital structure (or for a private company), you typically:

1. Unlever comparable companies’ equity betas to get an asset (unlevered) beta that represents business risk.
2. Take the average/median unlevered beta across the peer set.
3. Relever to the target’s capital structure to get the implied equity beta.

Keep formulas high level (interview-appropriate): unlevered beta removes the effect of debt; relevered beta adds it back based on the target D/E and tax rate assumptions. Call out the intuition: more leverage → higher equity beta, because equity becomes a smaller, riskier residual claim.

Wrap up by turning the framework into a 20–30 second calculation and interpretation.

Example structure:

• Choose realistic inputs (risk-free, equity risk premium, beta).
• Compute cost of equity with CAPM.
• State what that means for valuation: higher beta → higher discount rate → lower present value (all else equal).

Sanity checks interviewers like:

• Does the implied cost of equity seem plausible given the company’s sector and cyclicality?
• Does the beta align with the firm’s operating leverage and revenue sensitivity to the economy?
• If beta is extreme, is it a data issue (window/index) or a real business risk story?

End by reinforcing practical use: in banking, beta is mainly an input to cost of equity/WACC rather than an end in itself.