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https://en.wikipedia.org/wiki/Beta_(finance)
Beta (finance)
From Wikipedia, the free encyclopedia
Contents
1 Statistical estimation
1.1 Security market line
2 Choice of benchmark
3 Investing
4 Adding to a portfolio
5 Academic theory
6 Multiple beta model
7 Estimation of beta
8 Interpretations of Beta
9 Extreme and interesting cases
10 Criticism
11 See also
12 References
13 External links
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Statistical estimation
Beta is estimated by linear regression. Given an asset and a benchmark that we are interested in, we want to
find an approximate formula
where a,b is the correlation of the two returns, and a and b are the respective volatilities. Relationships
between standard deviation, variance and correlation:
Beta can be computed for prices in the past, where the data is known, which is historical beta. However,
what most people are interested in is future beta, which relates to risks going forward. Estimating future beta
is a difficult problem. One guess is that future beta equals historical beta.
From this, we find that beta can be explained as "correlated relative volatility". This has three components:
correlated
relative
volatility
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, its non-diversifiable risk, its systematic
risk, or market risk. On an individual asset level, measuring beta can give clues to volatility and liquidity in
the marketplace. In fund management, measuring beta is thought to separate a manager's skill from his or
her willingness to take risk.
The portfolio of interest in the CAPM formulation is the market portfolio that contains all risky assets, and
so the rb terms in the formula are replaced by rm, the rate of return of the market. The regression line is then
called the security characteristic line (SCL).
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It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected
return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected
return is plotted above the SML, it is undervalued because the investor can expect a greater return for the
inherent risk. A security plotted below the SML is overvalued because the investor would be accepting a
lower return for the amount of risk assumed.
Choice of benchmark
In the U.S., published betas typically use a stock market index such as the S&P 500 as a benchmark. The
S&P 500 is a popular index of U.S. large-cap stocks. Other choices may be an international index such as
the MSCI EAFE. The benchmark is often chosen to be similar to the assets chosen by the investor. For
example, for a person who owns S&P 500 index funds and gold bars, the index would combine the S&P 500
and the price of gold. In practice a standard index is used.
The choice of the index need not reflect the portfolio under question; e.g., 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. The restriction to stocks as a benchmark is somewhat arbitrary. A model
portfolio may be stocks plus bonds. Sometimes the market is defined as "all investable assets" (see Roll's
critique); unfortunately, this includes lots of things for which returns may be hard to measure.
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Investing
By definition, the market itself has a beta of 1.0, and individual stocks are ranked according to how much
they deviate from the macro market (for simplicity purposes, the S&P 500 is sometimes used as a proxy for
the market as a whole). A stock whose returns vary more than the market's returns over time can have a beta
whose absolute value is greater than 1.0 (whether it is, in fact, greater than 0 will depend on the correlation
of the stock's returns and the market's returns). A stock whose returns vary less than the market's returns has
a beta with an absolute value less than 1.0.
A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the overall market's
returns; when the market's return falls or rises by 3%, the stock's return will fall or rise (respectively) by 6%
on average. (However, because beta also depends on the correlation of returns, there can be considerable
variance about that average; the higher the correlation, the less variance; the lower the correlation, the higher
the variance.) Beta can also be negative, meaning the stock's returns tend to move in the opposite direction
of the market's returns. A stock with a beta of 3 would see its return decline 9% (on average) when the
market's return goes up 3%, and would see its return climb 9% (on average) if the market's return falls by
3%.
Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher returns.
Lower-beta stocks pose less risk but generally offer lower returns. Some have challenged this idea, claiming
that the data show little relation between beta and potential reward, or even that lower-beta stocks are both
less risky and more profitable (contradicting CAPM).[5] In the same way a stock's beta shows its relation to
market shifts, it is also an indicator for required returns on investment (ROI). Given a risk-free rate of 2%,
for example, if the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should
return 11% (= 2% + 1.5(8% 2%)) in accordance with the financial CAPM model.
Adding to a portfolio
Suppose an investor has all his money in an asset class X and wishes to move a small amount to an asset
class Y. For example, X could be U.S. stocks, while Y could be stocks of a different country, or bonds. Then
the new portfolio, Z, can be expressed symbolically
The first formula is exact, while the second one is only valid for small . Using the formula for of Y
relative to X,
we can compute
This suggests that an asset with greater than one will increase variance, while an asset with less than one
will decrease variance, if added in the right amount. This assumes that variance is an accurate measure of
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risk, which is usually good. However, the beta does need to be computed with respect to what the investor
currently owns.
Academic theory
Academic theory claims that higher-risk investments should have higher returns over the long-term. Wall
Street has a saying that "higher return requires higher risk", not that a risky investment will automatically do
better. Some things may just be poor investments (e.g., playing roulette). Further, highly rational investors
should consider correlated volatility (beta) instead of simple volatility (sigma). Theoretically, a negative beta
equity is possible; for example, an inverse ETF should have negative beta to the relevant index. Also, a short
position should have opposite beta.
This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using the capital
asset pricing model (CAPM). According to the model, the expected return on equity is a function of a firm's
equity beta (E) which, in turn, is a function of both leverage and asset risk (A):
where:
KE = firm's cost of equity
RF = risk-free rate (the rate of return on a "risk free investment"; e.g., U.S. Treasury Bonds)
RM = return on the market portfolio
because:
and
Firm value (V) + cash and risk-free securities = debt value (D) + equity value (E)
An indication of the systematic riskiness attaching to the returns on ordinary shares. It equates to the asset
Beta for an ungeared firm, or is adjusted upwards to reflect the extra riskiness of shares in a geared firm., i.e.
the Geared Beta.[6]
Estimation of beta
To estimate beta, one needs a list of returns for the asset and returns for the index; these returns can be daily,
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weekly or any period. Then one uses standard formulas from linear regression. The slope of the fitted line
from the linear least-squares calculation is the estimated Beta. The y-intercept is the alpha.
Myron Scholes and Joseph Williams (1977) provided a model for estimating betas from nonsynchronous
data.[7]
Beta specifically gives the volatility ratio multiplied by the correlation of the plotted data. To take an
extreme example, something may have a beta of zero even though it is highly volatile, provided it is
uncorrelated with the market. Tofallis (2008) provides a discussion of this,[8] together with a real example
involving AT&T Inc. 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.
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). Total beta captures the security's risk as
a stand-alone asset (because the correlation coefficient, R, has been removed from beta), rather than part of a
well-diversified portfolio. Because appraisers frequently value closely held companies as stand-alone assets,
total beta is gaining acceptance in the business valuation industry. Appraisers can now use total beta in the
following equation: total cost of equity (TCOE) = risk-free rate + total betaequity risk premium. Once
appraisers have a number of TCOE benchmarks, 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.
Interpretations of Beta
Some interpretations of beta are explained in the following table:[9]
Value of
Beta
Interpretation
Example
<0
=0
Movement of the asset is uncorrelated with Fixed-yield asset, whose growth is unrelated to the
the movement of the benchmark
movement of the stock market
0<<1
=1
>1
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. An alternative to standard beta is downside beta.
Beta is always measured in respect to some benchmark. Therefore an asset may have different betas
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depending on which benchmark is used. Just a number is useless if the benchmark is not known.
Criticism
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Seth Klarman of the Baupost group wrote in Margin of Safety: "I find it preposterous that a single number
reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views
risk solely from the perspective of market prices, failing to take into consideration specific business
fundamentals or economic developments. The price level is also ignored, 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. 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, or the ultimate purchase of
sufficient stock to gain corporate control and with it direct access to underlying value. 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. This too is inconsistent with the
world as we know it. 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."[10]
At the industry level, beta tends to underestimate downside beta two-thirds of the time (resulting in value
overestimation) and overestimate upside beta one-third of the time resulting in value underestimation.[11]
Another weakness of beta can be illustrated through an easy example by considering two hypothetical
stocks, A and B. The returns on A, B and the market follow the probability distribution below:
Probability Market Stock A Stock B
0.25
30%
15%
60%
0.25
15%
7.5%
30%
0.25
15%
30%
7.5%
0.25
30%
60%
15%
The table shows that stock A goes down half as much as the market when the market goes down and up
twice as much as the market when the market goes up. Stock B, on the other hand, goes down twice as much
as the market when the market goes down and up half as much as the market when the market goes up. Most
investors would label stock B as more risky. In fact, stock A has better return in every possible case.
However, according to the capital asset pricing model, stock A and B would have the same beta, meaning
that theoretically, investors would require the same rate of return for both stocks. This is an illustration of
how using standard beta might mislead investors. The dual-beta model, in contrast, takes into account this
issue and differentiates downside beta from upside beta, or downside risk from upside risk, and thus allows
investors to make better informed investing decisions.[11]
See also
Alpha (finance)
Beta Coefficient via
Wikinvest
Beta decay (finance)
Capital asset pricing model
CSS Theory - Beta
Cost of capital
Downside beta
Downside risk
Dual-beta
Financial risk
Hamada's equation
Macro risk
Treynor ratio
Upside beta
Upside risk
WACC
References
1. Sharpe, William (1970). Portfolio Theory and Capital Markets. McGraw-Hill Trade. ISBN 978-0071353205.
2. Markowitz, Harry (1958). Portfolio Selection. John Wiley & Sons. ISBN 978-1557861085.
3. Fama, Eugene (1976). Foundations of Finance: Portfolio Decisions and Securities Prices. Basic Books.
ISBN 978-0465024995.
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4. Ilmanen, Antti (2011). Expected Returns: An Investor's Guide to Harvesting Market Rewards. John Wiley &
Sons. ISBN 978-1119990727.
5. McAlpine, Chad (2010). "Low-risk TSX stocks have outearned riskiest peers over 30-year period"
(http://business.financialpost.com/2010/06/22/low-risk-tsx-stocks-have-outearned-riskiest-peers-over-30year-period-analyst/), The Financial Post Trading Desk, June 22, 2010
6. "Click here definition of Equity Beta, what is Equity Beta, what does Equity Beta mean? Finance Glossary Search our financial terms for a definition - London South East" (http://www.lse.co.uk
/financeglossary.asp?searchTerm=equity&iArticleID=1688&definition=equity_beta). Lse.co.uk. Retrieved
2012-12-03.
7. Scholes, Myron; Williams, Joseph (1977). "Estimating betas from nonsynchronous data". Journal of Financial
Economics 5 (3): 309327. doi:10.1016/0304-405X(77)90041-1 (https://dx.doi.org
/10.1016%2F0304-405X%2877%2990041-1).
8. Tofallis, Chris (2008). "Investment Volatility: A Critique of Standard Beta Estimation and a Simple Way
Forward". European Journal of Operational Research 187 (3): 13581367. doi:10.1016/j.ejor.2006.09.018
(https://dx.doi.org/10.1016%2Fj.ejor.2006.09.018).
9. Definition of Beta Definition via Wikinvest
10. Klarman, Seth; Williams, Joseph (1991). "Beta". Journal of Financial Economics 5 (3): 117.
doi:10.1016/0304-405X(77)90041-1 (https://dx.doi.org/10.1016%2F0304-405X%2877%2990041-1).
11. James Chong; Yanbo Jin; Michael Phillips (April 29, 2013). "The Entrepreneur's Cost of Capital: Incorporating
Downside Risk in the Buildup Method" (http://www.macrorisk.com/wp-content/uploads/2013/04/MRA-WP2013-e.pdf) (PDF). Retrieved 25 June 2013.
External links
ETFs & Diversification: A Study of Correlations (http://www.etf.com/sections/research/5911-etfs-adiversification.html?iu=1)
Leverage and diversification effects of public companies (http://rdcohen.50megs.com
/IDRHEqabstract.htm)
Calculate Beta in a Spreadsheet (http://investexcel.net/367/calculate-stock-beta-with-excel)
Retrieved from "https://en.wikipedia.org/w/index.php?title=Beta_(finance)&oldid=677781644"
Categories: Mathematical finance Fundamental analysis Financial ratios Statistical ratios
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