Question

Explain in words what beta is and why it is important. Select a company, go to yahoo finance, find the company’s beta and analyze this beta. Specifically, explain what the beta for the company means, and does it make sense given the industry this company is in?

Answer 1

Beta measures the contribution of a security to the variance of a diversified portfolio

=> Beta measures the systematic risk of a security. The higher the beta, the more sharply the value of theinvestment can be expected to fluctuate in relation to a market index.

Factors that determine Beta

Factors: Operating leverage, Cyclicality of revenues, financial leverage

Asset beta = Equity beta with no financial leverage

Equity beta > Asset beta with financial leverage

In finance, the beta (β or beta coefficient) of an investment indicates whether the investment is more or less volatile than the market as a whole. In general, a beta less than 1 indicates that of the investment is less volatile than the market, while a beta more than 1 indicates that the investment is more volatile than the market. Volatility is measured as the fluctuation of the price around the mean: the standard deviation.

Beta is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market. An example of the first is a treasury bill: the price does not go up or down a lot, so it has a low beta. An example of the second is gold. The price of gold does go up and down a lot, but not in the same direction or at the same time as the market.

A beta greater than one generally means that the asset both is volatile and tends to move up and down with the market. An example is a stock in a big technology company. Negative betas are possible for investments that tend to go down when the market goes up, and vice versa. There are few fundamental investments with consistent and significant negative betas, but some derivatives like put options can have large negative betas.

Beta is important because it measures the risk of an investment that cannot be reduced by diversification. It does not measure the risk of an investment held on a stand-alone basis, but the amount of risk the investment adds to an already-diversified portfolio. In the capital asset pricing model, beta risk is the only kind of risk for which investors should receive an expected return higher than the risk-free rate of interest.

The definition above covers only theoretical beta. The term is used in many related ways in finance. For example, the betas commonly quoted in mutual fund analyses generally measure the risk of the fund arising from exposure to a benchmark for the fund, rather than from exposure to the entire market portfolio. Thus they measure the amount of risk the fund adds to a diversified portfolio of funds of the same type, rather than to a portfolio diversified among all fund types.

Beta decay refers to the tendency for a company with a high beta coefficient (β > 1) to have its beta coefficient decline to the market beta. It is an example of regression toward the mean.