Question

(CAPM) talk about major determinants of Beta(β), and discuss at least 3 Problems with Estimating Beta(β) and Solution for them.

Answer 1

Beta in the capital asset pricing model (CAPM) refers to tool that measures the systematic risk or volatility of a portfolio, in relation to the entire market. The beta of an individual stock is a theoretical indication to an investor what could be the risk that this stock is likely to add or subtract from a diversified portfolio.

As per different studies, beta can be determined by the degree of operating leverage and systematic risk; the degree of financial leverage; and intrinsic business risk.

The first problem with Beta is that it is calculated using historical data. Two sub-issues arise here. One is the availability of historical data and the second is a lack of relevance of the figure in predicting the future movement of the portfolio or stock.

The second problem is, in theory, it is assumed that stock returns are normally distributed. However, financial markets are vulnerable, they can experience large surprises or shocks which makes returns not normally distributed. As a result, the Beta value calculated based on the assumption of a normal distribution of the stock returns often fails to offer a true reflection of the real-life movement of the stock.

The third problem with beta is that it is difficult to calculate proxy betas for project-specific discount rates.  Proxy companies seldom engage in single business activity. As a result, the proxy beta for a proposed investment project gets disentangled with the equity beat of the company. One method of resolving this problem is to use the equity beta like a portfolio beta, which is a weighted average of the betas of many different activity fields of proxy company. The weights will be the relative share of the market value of the proxy company that arise from each activity.