Question

a) Explain why adjustment to beta such as Blume’s and Vasicek’s are necessary.

b) Assume betas for two stocks A and B are estimated to be 1.6 and 0.7 respectively. Calculate adjusted betas by using Blume’s method.

Answer 1

Answers-

a)

Adjustment to Blume beta - The Blume adjustment corrects the estimated market beta of a security for the tendency of market betas to revert back to the value of 1.

Afdjustment to Vasicek's beta - The calculated beta's are having high degree of estimation error.

The econometric technique, the Vasicek adjustment, can mitigate estimation error and thereby increase the reliability of beta and ultimately cost of capital estimates.

b)

Adjusted beta by Blume method

For Stock A of 1.6

Adjusted beta = (2/3) x 1.6 + (1/3)

Adjusted beta = 0.667 x 1.6 + 0.333

Adjusted beta = 1.0672 + 0.333

Adjusted beta = 1.4

Adjusted Beta for Stock A = 1.4

For Stock B of 0.7

Adjusted beta = (2/3) x 0.7 + (1/3)

Adjusted beta = 0.667 x 0.7+ 0.333

Adjusted beta = 0.4669 + 0.333

Adjusted beta = 0.799 ~ 0.8

Adjusted Beta for Stock B = 0.8