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Jump to: navigation, search In finance, the Beta (β) of a stock or portfolio is a number describing the relation of its returns with those of the financial market as a whole. An asset has a Beta of zero if its returns change independently of changes in the market's returns. A positive beta means that the asset's returns generally follow the market's returns, in the sense that they both tend to be above their respective averages together, or both tend to be below their respective averages together. A negative beta means that the asset's returns generally move opposite the market's returns: one will tend to be above its average when the other is below its average. The beta coefficient is a key parameter in the capital asset pricing model (CAPM). It measures the part of the asset's statistical variance that cannot be removed by the diversification provided by the portfolio of many risky assets, because of the correlation of its returns with the returns of the other assets that are in the portfolio. Beta can be estimated for individual companies using regression analysis against a stock market index.
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1 Definition o 1.1 Security market line 2 Beta, volatility and correlation 3 Choice of benchmark 4 Investing 5 Academic theory 6 Multiple beta model 7 Estimation of beta 8 Extreme and interesting cases 9 Criticism 10 See also 11 Notes 12 External links
The formula for the beta of an asset within a portfolio is
If one of the managers' portfolios has an average beta of 3.0. Because this higher return is theoretically possible merely by taking a leveraged position in the broad market to double the beta so it is exactly 2. Beta is also referred to as financial elasticity or correlated relative volatility. we would expect a skilled portfolio manager to have built the outperforming portfolio with a beta somewhat less than 2. suppose two managers gain 50% above the risk free rate. It is linked to a regression analysis of the returns of a portfolio (such as a stock index) (x-axis) in a specific period versus the returns of an individual asset (y-axis) in a specific year. the rate of return of the market. and so the rp terms in the formula are replaced by rm. rp measures the rate of return of the portfolio.  Security market line Main article: Security market line The SML graphs the results from the capital asset pricing model (CAPM) formula. such that the excess return not explained by the beta is positive. its systematic risk. The portfolio of interest in the CAPM formulation is the market portfolio that contains all risky assets. in a year where the broad market or benchmark index returns 25% above the risk free rate.0. On an individual asset level. Whether investors can expect the second manager to duplicate that performance in future periods is of course a different question. The beta coefficient was born out of linear regression analysis. αa is called the asset's alpha and βa is called the asset's beta coefficient.where ra measures the rate of return of the asset. The xaxis represents the risk (beta). then the CAPM simply states that the extra return of the first manager is not sufficient to compensate us for that manager's risk. measuring beta is thought to separate a manager's skill from his or her willingness to take risk.5. and cov(ra.rp) is the covariance between the rates of return. The regression line is then called the Security characteristic Line (SCL). For an example. its non-diversifiable risk. In fund management. measuring beta can give clues to volatility and liquidity in the marketplace. whereas the second manager has done more than expected given the risk. Both coefficients have an important role in Modern portfolio theory. and the y-axis The Security Market Line . or market risk. and the other's has a beta of only 1. and can be referred to as a measure of the sensitivity of the asset's returns to market returns.
Individual securities are plotted on the SML graph.  Beta. If this were true. volatility and correlation A misconception about beta is that it measures the volatility of a security relative to the volatility of the market. The market risk premium is determined from the slope of the SML. For example. the formula relating beta (β). the relative volatility of the security (σ). because beta also incorporates the correlation of returns between the security and the market. In fact. it is undervalued because the investor can expect a greater return for the inherent risk. if market volatility is 10%. The relationship between β and required return is plotted on the security market line (SML) which shows expected return as a function of β. while the slope is E(Rm)− Rf. . This also leads to an inequality (because | ρ | is not greater than one): In other words. A security plotted below the SML is overvalued because the investor would be accepting a lower return for the amount of risk assumed. where Beta is exposure to changes in value of the Market. The equation of the SML is thus: It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. and the other stock has low correlation and high volatility. the correlation of returns (ρ) and the market volatility (σm) is For example.represents the expected return. The intercept is the nominal risk-free rate available for the market. If the security's risk versus expected return is plotted above the SML. if one stock has low volatility and high correlation. then a security with a beta of 1 would have the same volatility of returns as the volatility of market returns. any stock (or fund) with a beta of 1 must have volatility of at least 10%. this is not the case. By the definition of beta. beta can compare their correlated volatility. The security market line can be regarded as representing a single-factor model of the asset price. beta sets a floor on volatility.
not magnitude). because beta also depends on the correlation of returns. greater than 1. A model portfolio may be stocks plus bonds. In practice a standard index is used. for a person who owns S&P 500 index funds and gold bars. there can be considerable variance about that average. A stock with a beta of 2 has returns that change. The ideal index would match the portfolio. the higher the variance. e. the correlation is one (correlation measures direction. the S&P 500 is sometimes used as a proxy for the market as a whole). this includes lots of things for which returns may be hard to measure.g. The restriction to stocks as a benchmark is somewhat arbitrary. the less variance. A stock whose returns vary less than the market's returns has a beta with an absolute value less than 1.0 (whether it is.  Choice of benchmark Published betas typically use a stock market index such as S&P 500 as a benchmark. the higher the correlation. so in the same example the beta would be 2 (the stock is up twice as much as the market). by twice the magnitude of the overall market's returns.. on average.0 will depend on the correlation of the stock's returns and the market's returns). meaning the stock's returns tend to move in the . beta for gold bars compared to the S&P 500 may be low or negative carrying the information that gold does not track stocks and may provide a mechanism for reducing risk. when the market's return falls or rises by 3%.0. If the market is always up 10% and a stock is always up 20%. Sometimes the market is defined as "all investable assets" (see Roll's critique). beta takes into account both direction and magnitude. the stock's return will fall or rise (respectively) by 6% on average. The benchmark should be chosen to be similar to the other assets chosen by the investor. However.0. the lower the correlation.Another way of distinguishing between beta and correlation is to think about direction and magnitude. (However. The choice of the index need not reflect the portfolio under question.) Beta can also be negative. in fact. Other choices may be an international index such as the MSCI EAFE. the index would combine the S&P 500 and the price of gold.  Investing By definition. for example. and individual stocks are ranked according to how much they deviate from the macro market (for simplicity purposes. unfortunately. the market itself has a beta of 1. A stock whose returns vary more than the market's returns over time can have a beta whose absolute value is greater than 1.
According to the model. for example. a short position should have opposite beta. it is also an indicator for required returns on investment (ROI). e. Treasury Bonds) • RM = return on the market portfolio • • • . a firm's cost of equity. Theoretically. Higher-beta stocks tend to be more volatile and therefore riskier. can be estimated using the Capital Asset Pricing Model (CAPM). This expected return on equity. and would see its return climb 9% (on average) if the market's return falls by 3%. claiming that the data show little relation between beta and potential reward.. is a function of both leverage and asset risk (βA): KE = RF + βE(RM − RF) where: KE = firm's cost of equity RF = risk-free rate (the rate of return on a "risk free investment". Some things may just be poor investments (e.5(8% 2%)). Further. Given a risk-free rate of 2%. In the same way a stock's beta shows its relation to market shifts. or even that lower-beta stocks are both less risky and more profitable (contradicting CAPM). or equivalently. highly rational investors should consider correlated volatility (beta) instead of simple volatility (sigma). the expected return on equity is a function of a firm's equity beta (βE) which. playing roulette). Wall Street has a saying that "higher return requires higher risk".  Academic theory Academic theory claims that higher-risk investments should have higher returns over the long-term. Lower-beta stocks pose less risk but generally offer lower returns. a stock with a beta of 1. for example.g. U.. Also. an inverse ETF should have negative beta to the relevant index. not that a risky investment will automatically do better. if the market (with a beta of 1) has an expected return of 8%.g. a negative beta equity is possible. Some have challenged this idea. A stock with a beta of -3 would see its return decline 9% (on average) when the market's return goes up 3%.5 should return 11% (= 2% + 1.opposite direction of the market's returns. but provide the potential for higher returns. in turn.S.
because: and Firm Value (V) = Debt Value (D) + Equity Value (E) An indication of the systematic riskiness attaching to the returns on ordinary shares. Then one uses standard formulas from linear regression.  Multiple beta model The arbitrage pricing theory (APT) has multiple betas in its model. the Geared Beta. therefore one may find two stocks (or funds) with equal beta. APT has multiple risk factors. Myron Scholes and Joseph Williams (1977) provided a model for estimating betas from nonsynchronous data. but one may be a better investment. It equates to the asset Beta for an ungeared firm. If that were the case it should simply be the ratio of these volatilities. namely the overall market. i.  Estimation of beta To estimate beta. the standard estimation uses the slope of the least squares . or is adjusted upwards to reflect the extra riskiness of shares in a geared firm. Multiple-factor models contradict CAPM by claiming that some other factors can return. one needs a list of returns for the asset and returns for the index. weekly or any period. these returns can be daily.e. In contrast to the CAPM that has only one risk factor.. Each risk factor has a corresponding beta indicating the responsiveness of the asset being priced to that risk factor. The y-intercept is the alpha. In fact. Beta is commonly misexplained as asset volatility relative to market volatility. The slope of the fitted line from the linear least-squares calculation is the estimated Beta.
R. The relative volatility ratio described above is actually known as Total Beta (at least by appraisers who practice business valuation). Total Beta is equal to the identity: Beta/R or the standard deviation of the stock/standard deviation of the market (note: the relative volatility).  Extreme and interesting cases • Beta has no upper or lower bound. such as treasury bonds and cash. Some zero-beta assets are riskfree. An example would be betting on horse racing. Appraisers can now use Total Beta in the following equation: Total Cost of Equity (TCOE) = risk-free rate + Total Beta*Equity Risk Premium. • A negative beta might occur even when both the benchmark index and the stock under consideration . together with a real example involving AT&T. The graph showing monthly returns from AT&T is visibly more volatile than the index and yet the standard estimate of beta for this is less than one.regression line—this gives a slope which is less than the volatility ratio. • Beta can be zero. rather than part of a well-diversified portfolio. • A negative beta simply means that the stock is inversely correlated with the market. Once appraisers have a number of TCOE benchmarks. A beta can be zero simply because the correlation between that item's returns and the market's returns is zero. something may have a beta of zero even though it is highly volatile. To take an extreme example. simply because a beta is zero does not mean that it is risk-free. and betas as large as 3 or 4 will occur with highly volatile stocks. However. has been removed from Beta). but it is certainly not a risk-free endeavor. The correlation with the market will be zero. they can compare/contrast the risk factors present in these publicly-traded benchmarks and the risks in their closely-held company to better defend/support their valuations. Tofallis (2008) provides a discussion of this. Total Beta is gaining acceptance in the business valuation industry. Specifically it gives the volatility ratio multiplied by the correlation of the plotted data. Because appraisers frequently value closelyheld companies as stand-alone assets. Total Beta captures the security's risk as a stand-alone asset (because the correlation coefficient. provided it is uncorrelated with the market.
• If it were possible to invest in an asset with positive returns and beta −1 as well as in the market portfolio (which by definition has beta 1). much worse than the decline of the overall market. Utility stocks are thought to be less cyclical and have lower beta as well. However. Procter & Gamble. the various markets are now fairly correlated. World benchmarks such as S&P Global 100 have slightly lower betas than comparable US-only benchmarks such as S&P 100.have positive returns. An example is the dot-com bubble. betas from different countries are not comparable. it also fell sharply in the early 2000s. this profit would be unlimited. • 'Tech' stocks typically have higher beta. it would be possible to achieve a risk-free profit. • If beta is a result of regression of one stock against the market where it is quoted. • Staple stocks are thought to be less affected by cycles and usually have lower beta. Beta is a statistical variable and should be considered with its statistical significance (R square value of the regression line). It is possible that lower positive returns of the index coincide with higher positive returns of the stock. With the use of leverage. Higher R square value implies higher correlation and a stronger relationship between returns of the asset and benchmark index. • Foreign stocks may provide some diversification. is a classic example.  Criticism Seth Klarman of the Baupost group wrote in Margin of Safety: "I find it preposterous that a single number . in practice it is impossible to find an asset with beta −1 that does not introduce additional costs or risks. especially the US and Western Europe. The slope of the regression line in such a case will be negative. for similar reasons. Other similar ones are Philip Morris (tobacco) and Johnson & Johnson (Health & Consumer Goods). Most analyses consider only the magnitude of beta. Although tech did very well in the late 1990s. • Using beta as a measure of relative risk has its own limitations. this effect is not as good as it used to be. or vice versa. which makes soap. Of course.
such as Excel 1. Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests. failing to take into consideration specific business fundamentals or economic developments.html#ixzz1ZGBlvlmt A stock's beta theoretically measures price sensitivity compared with the market. Beta views risk solely from the perspective of market prices. Investors with multiple positions should consider their portfolio's beta. being simply a function of that investment's volatility compared with that of the market as a whole.com/how_6847626_calculate-beta-portfolio." How to Calculate the Beta of a Portfolio Read more: How to Calculate the Beta of a Portfolio | eHow.or long-term horizon and other factors affect beta. You should learn how to calculate your portfolio's beta for the greatest accuracy. Beta also assumes that the upside potential and downside risk of any investment are essentially equal. or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value.reflecting past price fluctuations could be thought to completely describe the risk in a security. a short. as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share. such as the S&P 500. Sophisticated investors may want to take a closer look at beta measurement. The price level is also ignored. Difficulty: Moderately Challenging Instructions Things You'll Need • Spreadsheet software. Calculation of beta requires a time horizon as well as measurement against a market standard. shareholder resolutions. This too is inconsistent with the world as we know it.ehow. communications with management. . International equities.com http://www. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.
she may adjust the portfolio's beta higher to create additional upward price sensitivity for portfolio holdings." In the authors' example. marketplace conditions and other factors. o 2 Adjusting your portfolio's beta may facilitate faster or slower moves when compared with the market. so the dynamic relationship of your portfolio's beta to the overall market. while best reflecting your investments. Use beta to calculate price sensitivity in equity and equity and debt portfolios. Use Excel or spreadsheet software to calculate and recalculate portfolio beta according to market. o 3 Use spreadsheet software to calculate and update your portfolio beta. according to "Modern Portfolio Theory and Investment Analysis" (2009). when an investment manager believes the market is about to rise. may help you best manage your money. Calculate the beta of your portfolio to position your holdings for moves with the market. "Beta is established from past information on the assumption that it will remain fairly stable over time. For example. and automatically update your portfolio's beta. According to the authors of "Financial Management" (2007). Compute beta using a simple calculation when your portfolio contains securities from one marketplace. portfolio beta is the weighted average of the individual betas of securities in the portfolio.o 1 Calculate portfolio beta to better understand the importance of diversification in risk management. Beta is seldom a static number. Know how to create a spreadsheet that will capture information at a glance. o 4 . The concept of investment timing requires the adjustment of portfolio beta prior to market moves. such as the S&P 500.
. and 40 percent is invested in a higher than market beta stock (1.10)(0. 20 percent is invested in a higher than market beta stock (1. While calculations are complex.67. The calculation.8) + (0. shows the portfolio beta is high relative to the market. knowing how much risk your portfolio bears is essential to sound money management.20)(1. A security assuming 40 percent of portfolio value is not the same as one assuming 10 percent.4).8). In this example. when your portfolio contains overweighted positions of any security. structured products and options have beta coefficients relative to the market. However. 10 percent of the portfolio is invested in a lower-than-market beta stock (0.40)(1. o 5 Understand that derivatives.9).8) + (0. where the market is 1. (0. your calculation should reflect the overweighting. overall portfolio risk would be better managed with greater position diversification.0).9) = 1.Adjust beta to the weighted position of each security in your portfolio.30)(1. Calculate the beta of your investments when evaluating the risk-to-reward potential of your portfolio.8.4) + (0. include these securities for an accurate picture. When calculating your portfolio beta. For example. 30 percent is invested in a higher than market beta stock (1. The portfolio's owner believes the market is going to rise.
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