Question

. The “beta” value of Amazon shares is about 1.7. The “beta” value of WalMart shares is about 0.3. According to Standard and Poors, WalMart’s bond rating is AA and Amazon’s rating is AA!.

1. What does the difference in beta values indicate?
2. What does the difference in bond ratings indicate?
3. What is meant by the riskiness of a stock? Can you determine, from the information provided, which of the two stocks is “riskier”?
4. Based on the information provided, do you expect Amazon stock or WalMart stock to produce a higher rate of return for the stockholder, or are the indications ambiguous?
5. Suppose that you had private information indicating that the economy is about to go into recession, information that you believe has not yet been incorporated into stock prices. How could this change your answer to part (d)?

Answer 1

a) Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

A beta value of less than 1.0 means that the security is theoretically less volatile than the market, meaning the portfolio is less risky with the stock included than without it. For example, utility stocks often have low betas because they tend to move more slowly than market averages.

A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the market. For example, if a stock's beta is 1.2, it is assumed to be 20% more volatile than the market. Technology stocks and small caps tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but also increase its expected return.

b) A bond rating is a rating that independent agencies issue to measure the credit quality of a particular bond. The bond rating measures the financial strength of the company issuing the bond, and its ability to make interest payments and repay the principal of the bond, when due.

Thousands of government agencies and private companies look to raise capital by issuing debt, and the bonds that they sell are popular investments among those looking for fixed income. However, the depth of the bond market can make it difficult for investors to assess whether one company is more or less likely to repay its debt than another. In order to simplify comparison of different bonds, bond-rating agencies make it their specialties to issue bond ratings for different bonds.

Bond ratings use a combination of letters, numbers, and symbols to indicate their relative placement on a given agency's rating scale. Letters generally indicate a broad range of ratings. Having more letters in the rating is generally better than fewer letters, and being earlier in the alphabet indicates higher quality.

For Standard and Poor's, AAA is the best rating, followed by AA, A, BBB, BB, B, CCC, CC, and C. D is used for bonds that are already in default. Fitch's ratings are similar to S&P. Moody's uses a slightly different scale, but its Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C ratings have roughly the same meaning.

From there, numbers or symbols further break down the letter-based rating. For example, with S&P and Fitch, a rating of AA+ is better than AA, and a rating of AA- is worse than AA, but better than A+. Moody's uses numbers to indicate relative quality, with Aa1 being the best Aa rating, followed by Aa2 and Aa3.

c) Risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.
simply, it is a measure of the level of uncertainty of achieving the returns as per the expectations of the investor. It is the extent of unexpected results to be realized.

A beta value more than 1.0 indicates that stock price is more volatile than the market, in the given question Amazon stock has beta value 1.7 and the Walmart stock beta value is 0.3, the it is clear that Amazon stock is more risky than Walmart.

d) We all know that in the business if we take more risk the return will be high, accordingly low risk will lead to low returns. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

Amazon stock is more risky than Walmart share as beta value is higher will lean to more returns than Walmart share to the investors.

e) There is no effect of recession on the Beta (β), It indicates that the market sensitivity
of above mentioned companies has not changed and traders
can follow the same trading strategy using Beta (β) as they
were following before recession. However, there is
significant effect of recession on the Beta (β) which indicates the dependency of their stock
prices has reduced and now the price movement of their
stock has become independent of index movement. Thus,
the traders has to change their trading strategy using Beta (β)
as they were following before recession.