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What is beta? How is it measured? What are the problems in beta estimation?
Beta is the measure of systematic risk and it is the ratio of covariance between
market return and the securitys return to the market return variance:
cov ar j, m
j =
2m
j m cor j, m
m m
j
m
cor j, m
Beta is also calculated by the market or index model. In the market model, we
regress returns on a security against returns of the market index. The market
model is given by the following regression equation:
R j = + jRm + ej
Do betas remain stable over time? What problem is posed by the instability of the
beta?
Betas may not remain stable for a company over time even if a company stays in
the same industry. There could be several reasons for this. Over time, a company
may witness changes in its product mix, technology, competition or market share.
In India, many industrial sectors are witnessing changes in competition and
How do you calculate the cost of equity using the CAPM framework?
From the firms point of view, the expected rate of return from a security of
equivalent risk is the cost of equity. The expected rate of return or the cost of
equity in CAPM is given by the following equation:
R j = k e = R f + (R m R f ) j
We need the following information to estimate a firms cost of equity:
1. The risk-free rate,
2. The market premium and
3. The beta of the firms share
Q4
A4