Notion of Beta

Risk - Overview
• Diversifiable – Can be eliminated thro diversification
• Non-Diversifiable – can not be eliminated
• The market will not reward an investor for holding
diversifiable risk
• The logic is simple : The investor is expected to
diversify such risk.
• By not diversifying, he is not efficient.
• Hence the relevant risk is only Non-Diversifiable risk –
ie) market risk
• Investor must how much he is taking non-diversifiable
risk in his investments.
 Systematic and Nonsystematic Risk
Can be eliminated by diversification

Nonsystematic
Risk

Total Risk

Systematic
Risk
 Principle 1
Beta - Beta is a measure of Non-
Diversifiable risk
• Beta is a measure of Non-Diversifiable risk
• Beta measures the sensitivity of the stock with
reference to a broad based market index , say
Sensex, Nifty, S&P 500 etc
• For instance Beta is 1.2 for a stock with regard to
an Index, means, stock is 20% risker than Index.
• Beta is 0.9 would indicate the stock is 10% less
risky than the index.
• Beta 1 would mean that stock is as risky as that of
the market index.
 Implications of Beta
• 1. Expected risk premium is Beta times the
market risk premium
• An investor gets extra reward for taking risk,
risk premium.
• If the stock market has a class (measured by
index) gives a risk premium say 10% and beta
is 1.2%, risk premium from the stock is
1.2times ie) 12%
 Implications of Beta
• 2. Beta measures the stock volatility with
reference to the market index.
• Means that the Beta of a stock indicates the
sensitivity of a stock to changes in the returns
from the stock market.
• If the stock market as a class (measured by
Index) changes by 5%, a stock with a beta of
1.2 should by 5 * 1.2 = 6%.
 Principle 2
How is Beta Useful ?
• Beta of a stock is any number
• If the Beta of a stock is greater >1, the stock is riskier
than the index or the stock market (high beta stock).
If the market falls down, the stock will fall quicker, if
the market goes up, the stock goes up faster.
• If the Beta of a stock is <1, the stock is less riskier
than the index (low beta stock).
• If the market falls down, the stock will fall slowly. If
the market goes up, the market goes slower.
• If the Beta is equal to 1, the stock will mimic the
market. They move in tandem with the market.
 Can Beta be Negative ?
• Yes. The beta of a stock can be negative.
• Say a gun or arms manufacturer- company stock,
will have a negative beta.
• In a war situation, market goes down, the arms
manufacturer’s company stock will go up. When
the war comes to close, the market goes up, the
arms manufacturer’s stock price comes down.
• Hence Beta of this kind of company will be
negative relate to market.
 How to calculate Beta of a single
security?
• Beta = ∑ XY - n 𝑋ത 𝑌ത /∑ Y2 – n 𝑌 2
• Beta =
• Covariance of stock & market / Variance of market
• Beta =
• 𝑆𝐷 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘/𝑆𝑑 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 ∗
𝐶𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑠𝑡𝑜𝑐𝑘 & 𝑠𝑡𝑜𝑐𝑘 𝑚𝑎𝑟𝑘𝑒𝑡
 Calculation and Interpretation of Beta

Cov  Ri , Rm  i ,m i m i ,m i
i   
m 2
m 2
m
0.026250 0.70  0.25  0.15 0.70  0.25
i     1.17
0.02250 0.02250 0.15

Market’s Asset’s Asset’s

Return Beta Return
EXHIBIT 6-6 Beta Estimation Using a Plot of
Security and Market Returns
Ri

Slope = β𝑖 [Beta]

Rm
Market Return
 Beta Contd.
• Though we cannot reduce market risks or systematic
risks but we can have a measure of these risks with
the help of beta.
• With the help of beta we can approximately tell how
much a particular stock will move if we know how
much the whole stock market is going to move.
• Thus, beta tells us what the volatility is in a particular
stock with respect to movements in the stock market.
• Beta is also referred to as financial elasticity or
correlated relative volatility.
 Basic Definition of Beta
• Beta measures the stock risks in relation to
the overall market.
• If Beta = 1: If Beta of the stock is one, then it
has the same level of risk as the stock market.
• Hence, if stock market (NASDAQ, NYSE etc)
rises up by 1%, the stock price will also move
up by 1%.
• If the stock market moves down by 1%, the
stock price will also move down by 1%.
 Beta > 1
• If Beta > 1: If the Beta of the stock is greater
than one, then it implies higher level of risk
and volatility as compared to the stock
market.
• Though the direction of the stock price change
will be same, however, the stock price
movements will be rather extremes.
 Beta > 1
• For example, assume the Beta of the ABC
stock is two, then if stock market moves up by
1%, the stock price of ABC will move up by
two percent (higher returns in the rising
market).
• However, if the stock market moves down by
1%, the stock price of ABC will move down by
two percent (thereby signifying higher
downside and risk).
 Beta >0 and Beta<1
• If Beta >0 and Beta<1: If the Beta of the stock is
less than one and greater than zero, it implies the
stock prices will move with the overall market,
however, the stock prices will remain less risky
and volatile.
• For example, if the beta of the stock XYZ is 0.5, it
means if the overall market moves up or down by
1%, XYZ stock price will show a an increase or
decrease of only 0.5% (less volatile)
 CALCULATION
• Beta is calculated on historical basis with the
help of historical returns on a particular stock
and historical returns on the stock market.
• The whole method consists of finding
covariance between the market returns and
stock returns and dividing it by the variance of
market returns.
• It is calculated with the help of the following
formula (next slide)
 CALCULATION
• Formula:

Where :
ra measures the rate of return of the stock
rp measures the rate of return of the portfolio
Cov(ra,rp) is the covariance between the rates of return
 BETA – USES AND FACTS
• Beta are calculated on historical prices thus it does
not provide the exact picture for future and are
backward looking
• Beta has no upper or lower bound, and betas as large
as 3 or 4 will occur with highly volatile stocks.
• Beta can be zero. Some zero-beta assets are risk-free,
such as treasury bonds. However, simply because a
beta is zero does NOT mean that it is risk free.
• A beta can be zero simply because the correlation
between that item and the market is zero.
• An example would be betting on horse racing. The
correlation with the market will be zero, but it is
certainly not a risk free endeavor.
 BETA – USES AND FACTS
• A negative beta simply means that the stock is
inversely correlated with the market.
• Many precious metals and precious-metal-related
stocks are beta-negative as their value tends to
increase when the general market is down and vice
versa.
• FMCG, Pharmaceutical stocks are thought to be less
affected by cycles and usually have lower beta.
Reality and infrastructure stocks have higher beta
and are more risky.
 Beta and large cos.
• In general, large companies with more
predictable Financial Statements and
profitability will have a lower beta value.
• For example, Energy, Utilities and Banks etc,
all tend to have lower beta.
• Most betas normally fall between 0.1 and 2.0
though negative and higher numbers are
possible.
 Key Determinants of Beta

• Now that we understood Beta as a measure of

Risk, it is important for us to also understand
the sources of risks.
• Beta depends on lot of factors – usually the
nature of business, operating and financial
leverages etc.
Determinants of Beta
 Beta determinants
• Nature of Business – The beta value for a firm depends on
the kind of products and services offered and its
relationship with the overall marco-economic environment.
Note that Cyclical companies have higher betas than non-
cyclical firms firms. Also, discretionary product firms will
have higher betas than firms that sell less discretionary
products
• Operating leverage: The greater the proportion of fixed
costs in the cost structure of the business, the higher the
beta
• Financial leverage: The more debt a firm takes on, the
higher the beta will be of the equity in that business. Debt
creates a fixed cost, interest expenses, that increases
exposure to market risks
 High Beta Stocks/Sectors
• Due to uncertain economic environment,
questions always remain on what is the best
investment strategy.
• Should I pick high CAPM Beta stocks or Low
CAPM Beta Stocks.
• It is normally understood that cyclical stocks
have high Beta and defensive sectors have low
Beta.
 High /Low Beta Stocks Sectors
• Cyclical stocks are those whose business
performance and stock performance is highly
correlated with the economic activities.
• If the economy is in recession, then these stock
exhibit poor results and thereby stock
performance takes a beating.
• Likewise, if the economic is on a high growth
trajectory, cyclical stocks tend to be highly
correlated and demonstrate high growth rate in
business and stock performances.
 Beta example
• Take for example, General Motors, its CAPM
Beta is 1.43.
• This implies if the stock market moves up by
5%, then General Motors stock will move up
by 5 x 1.43 = 7.15%.
 Cyclical sectors and tend to exhibit
High Stock Betas.
• Following sectors can be classified as cyclical
sectors and tend to exhibit High Stock Betas
– Automobiles Sector
– Materials Sector
– Information Technology Sector
– Consumer Discretionary Sector
– Industrial Sector
– Banking Sector
 Low Beta Stocks/Sectors

• Low Beta is demonstrated by stocks in defensive

sector. Defensive stocks are stocks whose business
activities and stock prices are not correlated with
the economic activities.
• Even if the economy is in recession, these stocks
tend to show stable revenues and stock prices.
• For example PepsiCo, its stock beta is 0.78. If the
stock market moves down by 5%, then Pepsico
stock will only move down by 0.78×5 = 3.9%.
 Low Stock Betas
• Following sectors can be classified as
defensive sectors and tend to exhibit Low
Stock Betas-
– Consumer Staples
– Beverages
– HealthCare
– Telecom
– Utilities
 BETA - Criticisms
• Past price fluctuations cannot completely
describe the risk in a security as past
fluctuation cannot give exact picture of future.

• Beta views risk solely from the perspective of

market prices, failing to take into
consideration specific business fundamentals
or economic developments.
 CONCLUSION
The reality is that past security price volatility
does not reliably predict future investment
performance (or even future volatility) and
therefore beta is not the perfect measure of
risks but it helps you to analyze in a broad
range how much your stock returns can
deviate and it is also an integral part capital
asset pricing theory which is used to calculate
required returns on a stock.
 How to Calculate Beta in Excel
• Step 1 : Download stock price of “X” for a
particular period
• Step 2 : Download stock price of an Index for
the similar period
• Step 3 : Calculate Return of Stock X and return
of Index
• Step 4 : Beta = Covariance (X, Index)/ Variance
of Index or Slope of (X, Index)
Portfolio Beta Calculation
 Beta Calculation example
• T-Bills give a return of 5%. Market return is
13%.
• Calculate the Beta based on the different
portfolio combinations listed below.

T Bill 100 70 30 0
Market 0 30 70 100
Portfolio Beta Calculation Example
• T-Bills return : 5% & Market return : 13%
• Note : Beta of T-Bills is zero & Beta of Market
is always 1
Portfolio T-Bills Market Beta
1 100 0 =100 *0+0*=0
2 70 30 =0.7*(0)+0.3*(1)=0.3
3 30 70 =0.30*(0)+0.7*1=0.7
4 0 100 =0.0*0 + 1.0 *1= 1