Question

Think about the ‘beta’ that is so popular in finance. a) What does it measure, and how is it calculated? [It may be good to refer to the previous question]. b) If I have a stock with a ‘beta’ of 1.25, what does this mean? c) Given its calculation, what really important assumption/set of assumptions are behind it? Discuss the problems associated with the ‘Beta’ in this regard. [This question is worth half the points].

Answer 1

Beta is the measurement of volatility or systematic risk of a security or portfolio compared to overall market. In other words it’s a measure of co-movement or sensitivity of a security or portfolio to the market. It gives an idea about how volatile an investment is compared to overall market. It describes the tendency of a security or portfolios returns to respond to market conditions. It expresses a tradeoff between minimizing risk & maximizing returns on an investment.

The higher the beta higher is the risk. A beta of 1 indicates that security will move with the market. A beta of less than 1 means that investment will be less volatile than market. A beta of greater than 1 denotes volatility is greater than market.

Assumptions:

1) The risk of an investment is made up of systematic risk & unsystematic risk. Systematic risk refers to the market risk associated with all securities. Unsystematic risk also called as diversifiable risk refers to the risk associated with individual assets.

2) Unsystematic risk can be reduced by including a greater number of assets in the portfolio.

3) Investors want maximum return on investment who choose investment based on expected returns.

4) Investors can borrow or lend unlimited amounts at a risk free (zero risk) rate.

5) All securities can be sold or purchased at any quantity & any time at market prices.

6) No investors has power to influence market.

7) The quantities of all financial assets are given & fixed.

Problems associated with Beta:

1) Beta only gives idea about past price fluctuations of common securities & it doesn’t give any new information.

2) It is very difficult to establish reliable beta for new listed securities which have insufficient price history.

3) It is less useful in assessing long time investments.