Question

Talk about major determinants of Beta (?), and discuss at least 3 Problems with Estimating Beta (?) and Solutions for them.

Answer 1

Major determinants of Beta (?)

Beta is a measure of risk associated with the stock returns with repect to the market returns

Business risk - This risk refers to the cyclicity of the earnings and the operating leverage of the company underlying the stock

Cyclicity of Revenues - Highly cyclical stocks have a higher beta, as these stocks are considered riskier because their earnings are volatile.

Operating leverage - This is a measure of how sensitive a firm is to its fixed costs. As fixed costs rise, variable costs fall. This metric is important as operating leverage magnifies the effect of cyclicity on beta. Higher the operating leverage, higher is the associated beta

Financial leverage - This refers to the proportion of debt and equity in the capital structure. A higher beta in the capital structure is associated with higher risk and hence higher beta.

Correlation between stock returns and market returns - Higher the correlation, higher is the beta. This implies that if the stock returns move in the same direction as the market returns, correlation is positive.

The standard deviation of the stock returns - Higher the standard deviation of the stock with respect to the standard deviation of market returns, higher is the beta, given that the correlation between stock returns and market returns is positive. This signifies than the volatility of the stock is higher, thus, a higher beta is needed to compensate the investors with higher returns

The standard deviation of the market returns - Higher the standard deviation of the market returns, lower is the probability of beta being higher. This is because beta is a measure of volatility with respect to the market returns.

3 Problems with Estimating Beta (?) and solutions

The biggest problem with estimating beta is associated with the data or the choice of the time period to be used for estimating beta. A company's financial and business position change often, and business or financial risk associated 5 years ago may not reflect its riskiness today. However, when we estimate the beta, we use previous returns which may not be reflective of the firm's risk in the future short term.

Here, we can use larger time frames for companies that had its business model and leverage fairly stable over time. For companies, which has recently restructed, a shorter time period must be used.

Choice of the market index - Since Beta of a stock is calculated with respect to market index returns, which market index to use is a challenge. Should the beta be estimated using a broader market index or only benchmark index is a challenge?

Here, we can use an index that has more number of securities since the index will remain highly diversified. Also, the market-weighted index must be used as the market's true return is more influenced by large capital companies than smaller ones.

Choice of the return interval - The return interval could be daily, weekly, monthly, quarterly or annual. Each return interval has a bearing on the beta. Which return interval to chose is a challenge.

Here, we can use longer return intervals ( as shorter return intervals are subject to illiquidity) but using the data for sufficiently long time frame. Other than this, the shorter return intervals can also be used, followed by adjusting the calculated beta for the extent of illiquidity.