Question

What does a beta coefficient measure?

(This will be a presentation question, please guide thoroughly. Thank you!)

Answer 1

What is beta?

Beta is a measurement of how volatile (risky) is your investment (stock) in the market. It takes into account both systematic and unsystematic risk.

What is beta coefficient?

Beta coefficient is a measure of the systematic risk of a security or a portfolio compared with the market as whole. It is widely used in the capital asset pricing model (CAPM) and security market line (SML).

Beta coefficient is an important input in the CAPM. CAPM estimates a stock's required rate of return (cost of equity)as the sum of the risk free interest rate and the stock's equity risk premium. A stock's equity risk premium is the product of the stock's beta coefficient and the market risk premium, the difference between equity market return and the risk free interest rate.

FORMULA:

= Cov(Ra, Rm) / Var (Rm)

where Cov(Ra, Rm) is a covariance between the return of a given security and market return, and Var (Rm) is a variance of market return.

Covariance (Re, Rm) = ( Re,n - Re, avg) * ( Rm,n - Rm, avg) / (n-1)

Variance(Rm) = (Rm, n- Rm, avg) / n

THE DIFFERENT MEASURES OF BETA:

1.=1

Exactly as volatile as the market. The security return and market return mov in the same direction and have equal volatility.

Market increases by 5 points, your investment increases by 5 points. Vice versa.

2.>1

More volatile than the market.The return of a security moves in the same direction as the market and has higher volatility than the market return.

Market increases by 5 points, your investment increased by 10 points.

3.<1

Less volatile than the market.Return of a security moves in the same direction as market return , but its volatility is less than market volatility.

Market increases by 5 points, your investments increases by 2.5 points.

4.<0

Negatively correlated to the market.Return of a security drives in the opposite direction from the market return. A negative value is very rare for long positions but is normal for short positions.

Market increases by 5 points, your investment falls by 5 points.

5.=0

Uncorrelated to the market.There is no correlation between a security return and the market return. For example cash under the condition of zero inflation because its value doesn't change over time unlike market return.

Market increases by 5 points, your investment has no effects.

EXAMPLE:

STOCKS RISK FREE RATE OF RETURN(Rf) MARKET RATE OF RETURN(Rm) BETA()

A 4% 6% 1

B 4% 6% 2

C 4% 6%    0.01

D 4% 6% -1

E 4% 6% 0

USING CAPM FORMULA (ERi) = Rf+ (Rm-Rf)

ERi is the expected return on the investment.

STOCK A= 4+1(6-4)=6

STOCK B= 4+2(6-4)=8

STOCK C= 4+0.01(6-4)= 4.02

STOCK D= 4+ (-1)(6-4)=2

STOCK E= 4+0(6-4)= 4

As in the above example you can see all the five measure of a beta.

SUMMARY

Beta coefficient is a financial metric that calculates the relationship between a stock's price and the volatility of the market.