Calculation of Beta ()

The risk of a well diversified portfolio, as we have seen, is represented by its market risk of the securities included in the portfolio. The market risk of a security reflects its sensitivity to market movements. Such sensitivity of a security is called beta (). As mentioned earlier, the beta for market portfolio is equal to 1 by definition. Beta of one (=1), indicates that volatility of return on the security is same as the market or index; beta more than one (>1) indicates that the sec urity has more unavoidable risk or is more volatile than market as a whole, and beta less than one (<1) indicates that the security has less systematic risk or is less volatile than market. Given return on security-X which is a dependent variable (Rx) and return on Market portfolio, the independent variable (R m), Beta for the security X is calculated by following formula: =

() cov( , )
m xm

Var R RR
228 Example 8: Given return on security-X and the return on Market portfolio, calculate beta of the security X: Year Return on Security X: (Rx) Return on Market Portfolio: (Rm)

Rx - Rx i Rm - Rm i (Rx - Rx) * i (Rm - Rm )

____ i

( Rm
2

- Rm i )

1 5 11 -2 2 -4 4 2 7 12 0 3 0 9 3 -3 -9 -10 -18 180 324 4 11 13 4 4 16 16 5 15 18 8 9 72 81 35 45 0 0 264 434 Expected return on Security X: Expected return on Market portfolio:
x

R=

5 5 7 31115
=

5 35
= 7 mR =

5 1112 9 13 18
=

5 45

=9 The covariance between return on security-X and the return on Market portfolio is:

cov xm
=

N-1 [(Rx - Rx ) (Rm - Rm ) ]

N i1 ____ ii

51 264
= 66 Variance of return on the market portfolio ( m 2 ) is calculated:
M

2 =
1 (Rm -Rm )2
____ i

N
=

51 434
= 108.5 Thus, beta of security X can be calculated as: x =

() cov( , )
m xm

Var R RR
=

108.5 66
= 0.61 Since Beta of Security X is 0.61 (which is less than 1), we may infer that its return is less volatile than the return on the market portfolio. If the return on market portfolio increases/decreases by 10% then return on security X would be expected to increase/decrease by 6.1% (0.61*10%).