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Complete Guide To Corporate Finance


Chapter One

Chapter Two

4.1 Net Present Value And


Internal Rate Of Return

Chapter Three

Chapter Four

Chapter Five

4.5.1 An Introduction To Risk And Return

AAA |

4.5.2 Expected Return, Variance And Standard Deviation

4.2 Capital Investment

Of A Portfolio

Decisions

4.5.3 Portfolios

4.3 Project Analysis And


Valuation

SIMULATOR

FAQs

4.5.4 Expected And Unexpected Returns


4.5.5 Systematic And Unsystematic Risk

Return, Risk And The Security Market Line Systematic And Unsystematic Risk
Unsystematic risk, also known as "specific risk," "diversifiable risk" or "residual
risk," is the type of uncertainty that comes with the company or industry you
invest in. Unsystematic risk can be reduced through diversification. For
example, news that is specific to a small number of stocks, such as a sudden
strike by the employees of a company you have shares in, is considered to be
unsystematic risk. Systematic risk,
risk also known as "market risk" or "undiversifiable risk", is the uncertainty inherent to the entire market or entire
market segment. Also referred to as volatility, systematic risk consists of the
day-to-day fluctuations in a stock's price. Volatility is a measure of risk because
it refers to the behavior, or "temperament," of your investment rather than the
reason for this behavior. Because market movement is the reason why people
can make money from stocks, volatility is essential for returns, and the more
unstable the investment the more chance there is that it will experience a
dramatic change in either direction.

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Interest rates, recession and wars all represent sources of systematic risk
because they affect the entire market and cannot be avoided through
diversification. Systematic risk can be mitigated only by being hedged.
Systematic risk underlies all other investment risks. If there is inflation, you can
invest in securities in inflation-resistant economic sectors. If interest rates are
high, you can sell your utility stocks and move into newly issued bonds.
However, if the entire economy underperforms, then the best you can do is
attempt to find investments that will weather the storm better than the broader
market. Popular examples are defensive industry stocks, for example, or bearish
options strategies.

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Beta is a measure of the volatility, or systematic risk, of a security or a portfolio


in comparison to the market as a whole. In other words, beta gives a sense of a
stock's market risk compared to the greater market. Beta is also used to compare
a stock's market risk to that of other stocks. Investment analysts use the Greek
letter '' to represent beta. Beta is used in the capital asset pricing model

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(CAPM), as we described in the previous section.


Beta is calculated using regression analysis, and you can think of beta as the
tendency of a security's returns to respond to swings in the market. A beta of 1
indicates that the security's price will move with the market. A beta of less than
1 means that the security will be less volatile than the market. A beta of greater
than 1 indicates that the security's price will be more volatile than the market.
For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the
market.
Many utility stocks have a beta of less than 1. Conversely, most high-tech
Nasdaq-based stocks have a beta greater than 1, offering the possibility of a
higher rate of return, but also posing more risk.
Beta helps us to understand the concepts of passive and active risk. The graph
below shows a time series of returns (each data point labeled "+") for a
particular portfolio R(p) versus the market return R(m). The returns are cashadjusted, so the point at which the x and y axes intersect is the cash-equivalent
return. Drawing a line of best fit through the data points allows us to quantify
the passive, or beta, risk and the active risk, which we refer to as alpha.

The gradient of the line is its beta. For example, a gradient of 1.0 indicates that
for every unit increase of market return, the portfolio return also increases by
one unit. A manager employing a passive management strategy can attempt to
increase the portfolio return by taking on more market risk (i.e., a beta greater
than 1) or alternatively decrease portfolio risk (and return) by reducing the
portfolio beta below 1. Essentially, beta expresses the fundamental tradeoff
between minimizing risk and maximizing return. Let's give an illustration. Say a
company has a beta of 2. This means it is two times as volatile as the overall
market. Let's say we expect the market to provide a return of 10% on an
investment. We would expect the company to return 20%. On the other hand, if
the market were to decline and provide a return of -6%, investors in that
company could expect a return of -12% (a loss of 12%). If a stock had a beta of
0.5, we would expect it to be half as volatile as the market: a market return of
10% would mean a 5% gain for the company. (For further reading, see Beta:
Know The Risk.)
Investors expecting the market to be bullish may choose funds exhibiting high
betas, which increase investors' chances of beating the market. If an investor
expects the market to be bearish in the near future, the funds that have betas
less than 1 are a good choice because they would be expected to decline less in
value than the index. For example, if a fund had a beta of 0.5 and the S&P 500
declined 6%, the fund would be expected to decline only 3%. (Learn more about
volatility in Understanding Volatility Measurements and Build Diversity
Through Beta.)
Here is a basic guide to various betas:
Negative beta - A beta less than 0 - which would indicate an inverse
relation to the market - is possible but highly unlikely. Some investors used

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to believe that gold and gold stocks should have negative betas because
they tended to do better when the stock market declined, but this hasn't
proved to be true over the long term.
Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of
which way the market moves, the value of cash remains unchanged (given
no inflation).
Beta between 0 and 1 - Companies with volatilities lower than the market
have a beta of less than 1 (but more than 0). Many utilities fall in this
range.
Beta of 1 - A beta of 1 represents the volatility of the given index used to
represent the overall market against which other stocks and their betas are
measured. The S&P 500 is such an index. If a stock has a beta of 1, it will
move the same amount and direction as the index. So, an index fund that
mirrors the S&P 500 will have a beta close to 1.
Beta greater than 1 - This denotes a volatility that is greater than the
broad-based index. Many technology companies on the Nasdaq have a beta
higher than 1.
Beta greater than 100 - This is impossible as it essentially denotes a
volatility that is 100 times greater than the market. If a stock had a beta of
100, it would be expected to go to 0 on any decline in the stock market. If
you ever see a beta of over 100 on a research site, it is usually either the
result of a statistical error or a sign that the given stock has experienced
large swings due to low liquidity, such as an over-the-counter stock. For
the most part, stocks of well-known companies rarely have a beta higher
than 4.
Why You Should Understand Beta
Are you prepared to take a loss on your investments? Many people are not and
therefore opt for investments with low volatility. Other people are willing to
take on additional risk because with it comes the possibility of increased reward.
It is very important that investors not only have a good understanding of their
risk tolerance, but also know which investments match their risk preferences.
By using beta to measure volatility,
you can better choose those
securities that meet your criteria for
risk. Investors who are very riskaverse should put their money into
investments with low betas such as
utility stocks and Treasury bills.
Those investors who are willing to
take on more risk may want to
invest in stocks with higher betas.
Many brokerage firms calculate the betas of securities they trade, and then
publish their calculations in a beta book. These books offer estimates of the beta
for almost any publicly-traded company. The problem is that most of us don't
have access to these brokerage books, and the calculation for beta can often be
confusing, even for experienced investors.
However, there are other resources. One of the better-known websites as of
2012 that publishes beta is Yahoo! Finance (enter a company's name, then click
on Key Statistics and look under Stock Price History). The beta calculated on
Yahoo! compares the activity of the stock over the last five years and compares
it to the S&P 500. A beta of "0.00" simply means that the stock either is a new
issue or doesn't yet have a beta calculated for it.
Warnings about Beta
The most important caveat for using beta to make investment decisions is that
beta is a historical measure of a stock's volatility. Past beta figures or historical
volatility do not necessarily predict future beta or future volatility. In other
words, if a stock's beta is 2 right now, there is no guarantee that in a year the

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beta will be the same. One study by Gene Fama and Ken French called "The
Cross-Section of Expected Stock Returns" (published in 1992 in the Journal of

Finance) on the reliability of past beta concluded that for individual stocks past
beta is not a good predictor of future beta. An interesting finding in this study is
that betas seem to revert back to the mean. This means that higher betas tend to
fall back toward 1 and lower betas tend to rise toward 1.
The second caveat for using beta is that it is a measure of systematic risk, which
is the risk that the market as a whole faces. The market index to which a stock is
being compared is affected by market-wide risks. So, since it is found by
comparing the volatility of a stock to the index, beta only takes into account the
effects of market-wide risks on the stock. The other risks companies face are
firm-specific risks, which are not grasped fully in the beta measure. So, while
beta will give investors a good idea about how changes in the market affect the
stock, it does not look at all the risks faced by the company alone.
The following is a chart of IBM's stock for the trading period of June 2004 to
June 2005. The red line is the IBM percent change over the period and the green
line is the percent change of the S&P 500. This chart helps to illustrate how IBM
moved in relation to the market, as represented by the S&P 500 during the oneyear period.

On June 8, 2005, the beta for IBM on Yahoo! was 1.636, meaning that up to that
point, IBM had the tendency to move more sharply in either direction compared
to the S&P 500. The chart above demonstrates IBM's tendency for higher
volatility. When the market moved up, IBM (red line) tended to move up more
(see the Oct.-to-Dec. range), and IBM's stock fell more than the market when it
declined (see the Jan.-to-Mar. range). The large drop in IBM stock from Mar to
Apr 2005, while coinciding with a smaller drop in the S&P, resulted from a firmspecific risk: the company missed its earnings estimates.
By showing IBM's behavior over this period, this chart demonstrates both the
value that comes with the use of beta and the caution that needs to be shown
when using it. It helps measure volatility, but it is not the whole story.
Analysts, brokers and planners have used beta for decades to help them
determine the risk level of an investment, and you should be aware of this risk
measure in your investment decision-making.

Next: Security Market Line And Beta Basics


Chapter One

Chapter Two

4.1 Net Present Value And


Internal Rate Of Return

Chapter Three

Chapter Four

Chapter Five

4.5.1 An Introduction To Risk And Return

http://www.investopedia.com/walkthrough/corporate-finance/4/return-risk/systematic... 26-04-2015

Systematic And Unsystematic Risk - Complete Guide To Corporate Finance | Investo...

4.2 Capital Investment


Decisions

4.3 Project Analysis And

Of A Portfolio

4.5.3 Portfolios

Valuation

4.5.2 Expected Return, Variance And Standard Deviation

Page 5 of 6

4.5.4 Expected And Unexpected Returns

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