BETA - CONCEPT

‡ In finance, the beta ( ) of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole. ‡ 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 mitigated 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 such as S&P 500.

BETA - CONCEPT
‡ The formula for the beta of an asset within a portfolio is ‡ where ra measures the rate of return of the asset, rp measures the rate of return of the portfolio, and cov(ra,rp) is the covariance between the rates of return. ‡ The portfolio of interest in the CAPM formulation is the market portfolio that contains all risky assets, and so the rp terms in the formula are replaced by rm, the rate of return of the market.

BETA - CONCEPT
‡ It Is non-diversifiable risk, its systematic risk, or market risk. ‡ Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns. ‡ measuring beta can give clues to volatility and liquidity in the marketplace

BETA - CONCEPT
‡ The beta coefficient was born out of linear regression analysis. 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 regression line is then called the Security characteristic Line (SCL). ‡ is called the asset's alpha and a is called the asset's beta coefficient. Both coefficients have an important role in Modern portfolio theory (APT).
a

The market risk premium is determined from the slope of the SML. while the slope is E(Rm)í Rf.BETA . and the y-axis represents the expected return.CONCEPT ‡ The SML graphs the results from the capital asset pricing model (CAPM) formula. . ‡ The relationship between and required return is plotted on the security market line (SML) which shows expected return as a function of . The x-axis represents the risk (beta). The intercept is the nominal risk-free rate available for the market.

BETA .CONCEPT .

A security plotted below the SML is overvalued because the investor would be accepting a lower return for the amount of risk assumed. . Individual securities are plotted on the SML graph. it is undervalued because the investor can expect a greater return for the inherent risk. If the security's risk versus expected return is plotted above the SML.BETA .CONCEPT ‡ It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk.

In fact. relative volatility (sigma) and correlation of returns is: . then a security with a beta of 1 would have the same volatility of returns as the volatility of market returns. this is not the case. If this were true.BETA .CONCEPT ‡ A misconception about beta is that it measures the volatility of a security relative to the volatility of the market. because beta also incorporates the correlation of returns between the security and the market. The formula relating beta.

‡ This also leads to an inequality (because |r| is not greater than one): explain -> ‡ In other words. .CONCEPT ‡ if one stock has low volatility and high correlation. if market volatility is 10%. any stock (or fund) with a beta of 1 must have volatility of at least 10%. and the other stock has low correlation and high volatility. For example.BETA . beta sets a floor on volatility. beta cannot decide which is more "risky".

CONCEPT ‡ Another way of distinguishing between beta and correlation is to think about direction and magnitude. the correlation is one (correlation measures direction. If the market is always up 10% and a stock is always up 20%. beta takes into account both direction and magnitude.BETA . so in the same example the beta would be 2 (the stock is up twice as much as the market). . not magnitude). However.

and betas as large as 3 or 4 will occur with highly volatile stocks.BETA . it is also an indicator for required returns on investment (ROI) or [E(R)] ‡ highly rational investors should consider correlated volatility (beta) instead of simple volatility (sigma).CONCEPT ‡ a stock's beta shows its relation to market shifts. ‡ Beta has no upper or lower bound. .

but it is certainly not a risk-free endeavor. such as treasury bonds and cash. ‡ An example would be betting on horse racing. ‡ However. Some zero-beta assets are risk-free. A beta can be zero simply because the correlation between that item's returns and the market's returns is zero.BETA VALUES ‡ Beta can be zero. . simply because a beta is zero does not mean that it is risk-free. The correlation with the market will be zero.

beta) in such a case will be negative.. . ‡ A negative beta might occur even when both the benchmark index and the stock under consideration have positive returns.BETA VALUES ‡ A negative beta simply means that the stock is inversely correlated with the market. or vice versa. The slope of the regression line (i. It is possible that lower positive returns of the index coincide with higher positive returns of the stock.e. ‡ Example : Many precious metals and precious-metalrelated stocks are beta-negative as their value tends to increase when the general market is down and vice versa.

Procter & Gamble.BETA VALUES ‡ If beta is a result of regression of one stock against the market where it is quoted. is a classic example. ‡ Staple stocks are thought to be less affected by cycles and usually have lower beta. . betas from different countries are not comparable. which makes soap. Other similar ones are Philip Morris (tobacco) and Johnson & Johnson(Health & Consumer Goods). Utility stocks are thought to be less cyclical and have lower beta as well.

much worse than the decline of the overall market. it also fell sharply in the early 2000s.BETA VALUES ‡ 'Tech' stocks typically have higher beta. ‡ Beta has no upper or lower bound. ‡ An example is the dot-com bubble. Although tech did very well in the late 1990s. and betas as large as 3 or 4 will occur with highly volatile stocks. .

idle cash sitting always remains the same (with no inflation). This is because a small change in the returns of the stock will make the stock price go to $0. ‡ Beta of 0 Value of current cash (with no inflation) has a Beta of 0. . ‡ Beta 0 . ‡ Beta >1 Stocks with a Beta of >1 are more volatile than the stock market.Analysis of Common Stock Betas ‡ Negative Beta Shows an inverse relation to the stock market and is highly unlikely. ‡ Beta of 1 A Beta of 1 means the stock market is moving in the same direction as the Market Index such as S&P 500. Beta >100 This is impossible. Why? This is because as technology becomes rapidly advanced. This commonly includes high-tech stocks. No matter how the market performs. outdated technology is useless. Many companies are thus wiped out due to out-dated technology. Gold Stocks though fall into this category. A stock can never be 100 times more riskier than the stock market in general. Commonly includes utility company stocks.1 These stocks are less volatile than the stock market in general.

CRITICISM OF BETA ‡ Beta views risk solely from the perspective of market prices. ‡ Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests. . shareholder resolutions. communications with management.(qualitative things) ‡ Beta also assumes that the upside potential and downside risk of any investment are essentially equal. being simply a function of that investment's volatility compared with that of the market as a whole. or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value. failing to take into consideration specific business fundamentals or economic developments.

M)/ VAR(M) . . M=MKT.BETA ESTIMATION ‡ DIRECT METHOD: RATIO OF COV. S=SECURITY. B/W MARKET RETURN AND SECURITY S RETURN TO THE MARKET RETURN VARIANCE. ‡ = COV(S.

CALCULATE DEVIATIONS ON RETURN ON SECURITY FROM AVG RETURN.TAKE SUM AND DIVIDE BY NO. OF OBSERVATIONS. 2.STEPS 1. 4. MULTIPLY DEVIATIONS OF MARKRT RETURN AND DEVIATION OF SECURITY S RETURN. CALCULATE DEVIATIONS ON RETURN ON MARKET FROM AVG RETURN. . CALCULATE AVERAGE RETURN ON MARKET AND THE SECURITY. 3.

STEPS CONTD. 6. OF OBSERVATIONS (AVG) TO GET VARIANCE OF MARKET RETURN.. DIVIDE THE COV OF MARKET AND SECURITY WITH THE VARIANCE OF THE MARKET. THIS IS BETA. NOW DIVIDE THE SUM OF SQUARED DEVIATIONS BY NO. 5. CALCULATE SQUARED DEVIATIONS OF MARKET RETURNS. .

BETA ESTIMATION ‡ MARKET(INDEX) MODEL: REGRESS RETURNS ON A SECURITY AGAINST RETURNS OF MARKET INDEX ‡ R j= + J R m + e J R j= E(R)ON SECURITY J R m IS EXPECTED MKT RETURN J IS SLOPE OF REGRESSION e J IS ERROR TERM .

BETA.DETERMINANTS ‡ Nature of business (cycles). . Eg commodity goods vs utility. so variability in ebit is due to FC Higher the dol higher the risk. ie high beta. ‡ Operating leverage use of fixed costs Dol = ( ebit/ebit)/( sales/sales) VC sales FC const.

Any firm with debt. There are fixed interests (financial FC) and cause ¨ in ebit ‡ Dfl = (¨ eps)/ (¨ ebit/ebit) ‡ As fl of a firm increases the e of firm also increases. Structure.levered firm. .BETA.DETERMINANTS ‡ Financial leverage: refers to debt in a firjms cap.

a stock with a beta of 1 would also move 2%.example ‡ Standard & Poor's 500 Index (S&P 500) has a beta coefficient (or base) of 1. or 3%).03.5 beta = 0. But a stock with a beta lower than 1 would be expected to be more stable in price and move less .5 would move 3% (2% increase x 1. ‡ Under the same market conditions. That means if the S&P 500 moves 2% in either direction. a stock with a beta of 1. however.

50.the portfolio beta is 1. A beta of more than 1 indicates greater volatility while a beta of less than 1 indicates less. A beta of 1 means that the portfolio is neither more nor less volatile or risky than the wider market.00. According to the proportions of the investments in the portfolio. and 50% of the money is in stock B with a beta of 1. ‡ A measure of a portfolio's volatility. ‡ Example: if 50% of the money is in stock A with a beta of 2.00. .PORTFOLIO BETA ‡ The beta of a portfolio is the weighted sum of the individual asset betas. Beta is an important component of the Capital Asset Pricing Model. which attempts to use volatility and risk to estimate expected returns.

‡ p = w1 1 + ««+ wn n .PORTFOLIO BETA ‡ Portfolio betas tend to be more stable than individual security betas.

‡ It is determined by adding the weighted cost of debt to the weighted cost of equity to determine the required rate of return.PROJECT BETA ‡ For evaluation of the projects institutional discount rates are established and applied to the analysis of all projects. . ‡ Institutional discount rates are determined by calculating an organization's weighted average cost of capital (WACC) Often the weighted average of the cost of equity and the cost of debt The weights are determined by the relative proportions of equity and debt.

PROJECT BETA ‡ For example. while the cost of equity is 15 percent and equity constitutes 80 percent of your capital structure. hurdle rate is 13% . ‡ Therefore. your required rate of return (discount rate. The weighted average cost of capital (WACC) is then: WACC= (5%)(20%) + (15%)(80%) = 1% + 12% = 13%. assume that the cost of debt is 5 percent and that debt makes up 20 percent of your capital structure.

then your cost of debt is: Cost of Debt = I (1-t) Cost of Debt = 5% x (1 . For example. and your corporate tax rate is 22 percent.PROJECT BETA ‡ Cost of debt is determined by how much an organization pays in interest on its debt multiplied by one minus the tax rate.22%) = 4% . if your debt rate is 5 percent.

The most commonly accepted method in finance is the capital asset pricing model (CAPM) ‡ An economic theory that describes the relationship between risk and expected return. which represents the measure of a company's risk relative to the overall market. and serves as a model for the pricing of risky securities.PROJECT BETA ‡ The cost of equity is more difficult to determine. . expected rate of return and beta. ‡ three major elements to the CAPM.risk free rate.

Beta is the slope of the "best fit" line.PROJECT BETA ‡ Taking a company's returns and plotting them against the returns of the S & P 500 determines beta. ‡ analysis is then used to determine the slope of the "best fit" line through the plotted points. .

PROJECT BETA ‡ The beta used to determine risk. and from that. WACC. or new piece of equipment. ‡ It does not reflect the risk associated with the Incremental cash flows associated with a new project. and the discount rate for an institution is a reflection of the risk of the entire organization's cash flow. cost of equity. . new building.

PROJECT BETA ‡ Estimating Beta In risk analysis.Pure-play method 2. estimating the beta of a project is quite important. The two most widely used methods of estimating beta are: 1. it can be difficult to determine.Accounting-beta method . But like many estimations.

a company seeks out companies with a product line that is similar to the line for which the company is trying to estimate the beta. Newco can take the average beta of other beer makers. Once these companies are found. to determine the beta of the new beer project. such as Anheuser Busch and Coors. Example : Newco would like to add beer to its existing product line of soda. However. the company would then take an average of those betas to determine its project beta. determining the beta for beer is not as intuitive for Newco as it has never produced it. .PROJECT BETA ‡ Pure-Play Method When using the pure-play method. Thus. Newco is quite familiar with the beta of making soda given its history.

such as the S&P 500.PROJECT BETA ‡ When using the accounting-beta method. . a company would run a regression using the company's return on assets (ROA) against the ROA for market benchmark.

. The historical Beta is the first step in the determination of the ex-ante Beta. If we are thinking of a new Company for a single project. we can determine Beta. first taking the historical records of this as well as other similar Companies and then by modifying the findings. riskfree rate and market return. we will have no historical records to go by. In case the Company has been existence for some time. We would then compute the Beta of companies of the same size and about the same lines of business and after making necessary adjustments to it. take it as the Beta for the firm.The determination of cost of capital under the CAPM approach involves the estimation of Beta. Beta is generally determined by comparing the return of the firm or the project as the case may be with the market return and ascertaining the relationship. Either the historical Beta can be accepted as the proxy for the future Beta or modifications can be made to it to conform to the future.

the company's WACC would be adjusted higher and if the project is less risky. 2. The cost of capital then must be adjusted for the riskiness of the project. ‡ For projects that are riskier. by adjusting the company's cost of capital either up or down depending on the risk of the project relative to the firm. A company first begins with its cost of capital for the firm. the company's WACC is adjusted lower ( because average cost of capital may not always reflect the extreme cases) The main issue in this procedure is that it is subjective. .PROJECT BETA Typical procedure for developing a risk-adjusted discount rate is as follows: 1.

6 and on being taken up would require 25% of the total resources of the Company.4*40/100)=11.2=13.4% as follows: 5%+(12-5)1. That project has a Beta of 3.numerical ‡ An illustration Let us assume that a Company has a Beta of 1.4% Let us also assume that the Debt-Equity ratio is 60:40 and that the cost of debt post-tax is 10%.36% Now a new project is being considered for expansion of activities. The cost of capital of equity of the Company under the CAPM model would work out to 13.2. The weighted average cost of capital would then be (10*60/100)+(13. . The risk-free rate of interest is 5% and the expected return on the market is 12%.

75*11.08% as follows: Let the return from the new project be x 0.6*25%)=1.36+0.8 So.6*40%=13.2*75%)+(3.04% Solving.04%.04% In order to meet the WACC of 13.8=17.6% Consequently the new WACC would be 10*60%+17. we get x=18.08% .25*x=13.We can thus gather that the Beta of the Company as a whole after taking up the project would be (1. the new project must generate 18. the new cost of equity would be 5%+(12-5)1.

we can arrive at their respective costs of capital.‡ An alternative approach The required return of 18.08% can also be ascertained by another method.6=30. The weighted average cost of capital of the new project alone will thus be 30. The equity component of the new project then will have a cost of 5% +(12-5)3.08 .2%.2*40%+10*60%=18. Taking each project as a separate entity.

‡ If the Company is entirely equity based. Robert Hamada brought out formulae for ascertaining Levered Beta given the unlevered beta and also to find out unlevered Beta given the levered Beta. A number of factors like default risk. ‡ For the sake of convenience. its Beta is likely to be lower than if it undertakes a borrowing. ‡ . let us call the Beta of a firm which is levered as Levered Beta and that of a firm on an all-equity structure as Unlevered Beta. bankruptcy risk and agency costs contribute to this phenomenon.The Hamada formula for adjusting the Leverage factor The Beta that we impute to a project is likely to undergo changes with the change in the capital structure of the Company.

‡ Levered Beta (or equity beta)= Risk of Equity ‡ Unlevered Beta (Asset beta) = Risk of Entire Firm (Assets) ‡ Firm Value (V) = Debt Value (D) + Equity Value (E) .GEARED AND UNGEARED BETA ‡ Also called levered and unlevered beta.

GEARED AND UNGEARED BETA Beta of a Unlevered Firm Beta of an Unlevered Firm BU=BL(1+(1-T)D/S). where BU= Beta of an unlevered firm BL=Beta of a levered firm T=tax rate D=component of Debt in capital structure S=component of Equity in capital structure .

GEARED AND UNGEARED BETA Beta of a Levered Firm BL=BU(1+(1-T)D/S). where BL=Beta of a levered firm BU= Beta of an unlevered firm T=tax rate D=component of Debt in capital structure S=component of Equity in capital structure .

GEARED AND UNGEARED BETA Given the Beta of a firm which is already levered. This also means that if the target firm has leverage different from the structure assumed in estimating the levered Beta. we can ascertain what its Beta would be if it chooses on all-equity structure. this can first be converted into an unlevered Beta and then reconverted into a levered Beta using the leverage parameters relevant to the firm. .

23 and 1.example Suppose there are three firms P.64)(0. Translating these into the Hamada formula for unlevered firms we get: BU=BL/(1+(1-T)(D/S)) =2.23. The average stock Beta works out to 2. The stock Betas of the three firms are taken and found to be 2.73 respectively for P.23/(I+0. Q and R.73. The marginal tax rate is 36%.67. 2. Q and R.56 .67)=1. which closely resemble project X that is to be embarked upon. The Ratio of Debt to Equity for the three firms averages to 0.

on a 1:1 debt equity ratio.5)=2.60)(0.If the project is proposed to be financed by 50% equity and 50% debt. This Beta can be used now for determining the cost of equity for the project and its weighted average cost of capital. so that a more meaningful appraisal can be had. the Beta will be 2.5.56(1+0.5 So. . we can modify the above Beta by applying the Hamada formula for Levered firms: BL=BU((I-T)D/S) =1.5/0.