Question

Briefly define beta, systematic risk and expected return and explain the relationship between them as they relate to investment management.

Answer 1

A) Beta coefficient is the measure of volatility of a stock as compared to the market. The market is said to have a Beta of 1. IF a stock has Beta > 1, the stock is said to be more volatile than the market, however, if the Beta < 1, the stock is said to be less volatile than the market. Beta is also called systematic risk.

B) Systematic risk, also known as market risk or undiversifiable risk, refers to the uncertainty inherent to whole of financial market / segment of market. This type of risk can not be eliminated by diversifying the investments into different assets, hence, this risk is not diversifiable. Systematic risk is symbolized by Beta.

C) Expected return is the profit / loss that an investor expects from its investment. Usually, it is calculated based on the probabilities of different scenarios and different market returns for the investment. The expected return is calculated as the mean of different market returns. i.e sum of (probability * return for each scenario).

Expected return is based on the expected price of the stock, and the price of stock is determined by the volatility of stock. A stock with higher beta is more volatile, which mean it has more chances of changes in prices making it difficult to expect a return. Usually, an investor expects more return when the risk is higher, i.e. when Beta is higher and stock is volatile, an investor expects more return.

This gives rise to Capital asset pricing model, according to which:-

E(R) = Rf + (Rm-Rf)*B

where E(R) = Expected return

Rf = Return on a risk free asset

Rm = market return

B = Beta of stock

hence, it implies that with increasing Beta, the expected price also increases at a rate of Market return - risk free return.