In finance, the beta () of a stock or portfolio is a number describing the relation of its returns with that of the financial

market as a whole. The beta coefficient is a key parameter in the capital asset pricing model (CAPM). It measures the part of the asset's statistical variance that cannot be mitigated by the diversification provided by the portfolio of many risky assets, because of the correlation of its returns with the returns of the other assets that are in the portfolio. Beta can be estimated for individual companies using regression analysis against a stock market index such as S&P 500.

 The formula for the beta of an asset within a portfolio is where ra measures the rate of return of the asset, rp measures the rate of return of the portfolio, and cov(ra,rp) is the covariance between the rates of return. The portfolio of interest in the CAPM formulation is the market portfolio that contains all risky assets, and so the rp terms in the formula are replaced by rm, the rate of return of the market.

 It Is non-diversifiable risk, its systematic risk, or market risk. Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns. measuring beta can give clues to volatility and liquidity in the marketplace

 The beta coefficient was born out of linear regression analysis. It is linked to a regression analysis of the returns of a portfolio (such as a stock index) (x-axis) in a specific period versus the returns of an individual asset (y-axis) in a specific year. The regression line is then called the Security characteristic Line (SCL). a is called the asset's alpha and a is called the asset's beta coefficient. Both coefficients have an important role in Modern portfolio theory (APT).

BETA - CONCEPT
The SML graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the security market line (SML) which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is E(Rm) Rf.

BETA - CONCEPT

BETA - CONCEPT
It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting a lower return for the amount of risk assumed.

BETA - CONCEPT
A misconception about beta is that it measures the volatility of a security relative to the volatility of the market. If this were true, then a security with a beta of 1 would have the same volatility of returns as the volatility of market returns. In fact, this is not the case, because beta also incorporates the correlation of returns between the security and the market. The formula relating beta, relative volatility (sigma) and correlation of returns is:

BETA - CONCEPT
if one stock has low volatility and high correlation, and the other stock has low correlation and high volatility, beta cannot decide which is more "risky". This also leads to an inequality (because |r| is not greater than one): explain -> In other words, beta sets a floor on volatility. For example, if market volatility is 10%, any stock (or fund) with a beta of 1 must have volatility of at least 10%.

BETA - CONCEPT
Another way of distinguishing between beta and correlation is to think about direction and magnitude. If the market is always up 10% and a stock is always up 20%, the correlation is one (correlation measures direction, not magnitude). However, beta takes into account both direction and magnitude, so in the same example the beta would be 2 (the stock is up twice as much as the market).

BETA - CONCEPT
a stock's beta shows its relation to market shifts, it is also an indicator for required returns on investment (ROI) or [E(R)] highly rational investors should consider correlated volatility (beta) instead of simple volatility (sigma). Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.

BETA VALUES
Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds and cash. However, simply because a beta is zero does not mean that it is risk-free. A beta can be zero simply because the correlation between that item's returns and the market's returns is zero. An example would be betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk-free endeavor.

BETA VALUES
A negative beta simply means that the stock is inversely correlated with the market. Example : Many precious metals and precious-metalrelated stocks are beta-negative as their value tends to increase when the general market is down and vice versa. A negative beta might occur even when both the benchmark index and the stock under consideration have positive returns. It is possible that lower positive returns of the index coincide with higher positive returns of the stock, or vice versa. The slope of the regression line (i.e., beta) in such a case will be negative.

BETA VALUES
If beta is a result of regression of one stock against the market where it is quoted, betas from different countries are not comparable. Staple stocks are thought to be less affected by cycles and usually have lower beta. Procter & Gamble, which makes soap, is a classic example. Other similar ones are Philip Morris (tobacco) and Johnson & Johnson(Health & Consumer Goods). Utility stocks are thought to be less cyclical and have lower beta as well.

BETA VALUES
'Tech' stocks typically have higher beta. An example is the dot-com bubble. Although tech did very well in the late 1990s, it also fell sharply in the early 2000s, much worse than the decline of the overall market. Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.

Analysis of Common Stock Betas

Negative Beta Shows an inverse relation to the stock market and is highly unlikely. Gold Stocks though fall into this category. Beta of 0 Value of current cash (with no inflation) has a Beta of 0. No matter how the market performs, idle cash sitting always remains the same (with no inflation). Beta 0 - 1 These stocks are less volatile than the stock market in general. Commonly includes utility company stocks. Beta of 1 A Beta of 1 means the stock market is moving in the same direction as the Market Index such as S&P 500. Beta >1 Stocks with a Beta of >1 are more volatile than the stock market. This commonly includes high-tech stocks. Why? This is because as technology becomes rapidly advanced, outdated technology is useless. Many companies are thus wiped out due to out-dated technology. Beta >100 This is impossible. A stock can never be 100 times more riskier than the stock market in general. This is because a small change in the returns of the stock will make the stock price go to $0.

CRITICISM OF BETA
Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value.(qualitative things) Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment's volatility compared with that of the market as a whole.

BETA ESTIMATION
DIRECT METHOD: RATIO OF COV. B/W MARKET RETURN AND SECURITYS RETURN TO THE MARKET RETURN VARIANCE. = COV(S,M)/ VAR(M) ; S=SECURITY, M=MKT.

STEPS
1. CALCULATE AVERAGE RETURN ON MARKET AND THE SECURITY. 2. CALCULATE DEVIATIONS ON RETURN ON MARKET FROM AVG RETURN. 3. CALCULATE DEVIATIONS ON RETURN ON SECURITY FROM AVG RETURN. 4. MULTIPLY DEVIATIONS OF MARKRT RETURN AND DEVIATION OF SECURITYS RETURN.TAKE SUM AND DIVIDE BY NO. OF OBSERVATIONS.

STEPS CONTD..
5. CALCULATE SQUARED DEVIATIONS OF MARKET RETURNS. NOW DIVIDE THE SUM OF SQUARED DEVIATIONS BY NO. OF OBSERVATIONS (AVG) TO GET VARIANCE OF MARKET RETURN. 6. DIVIDE THE COV OF MARKET AND SECURITY WITH THE VARIANCE OF THE MARKET. THIS IS BETA.

BETA ESTIMATION
MARKET(INDEX) MODEL: REGRESS RETURNS ON A SECURITY AGAINST RETURNS OF MARKET INDEX R j= + J R m + e J R j= E(R)ON SECURITY J R m IS EXPECTED MKT RETURN J IS SLOPE OF REGRESSION e J IS ERROR TERM

BETA- DETERMINANTS
Nature of business (cycles). Eg commodity goods vs utility. Operating leverage use of fixed costs Dol = (ebit/ebit)/(sales/sales) VC sales FC const. so variability in ebit is due to FC Higher the dol higher the risk, ie high beta.

BETA- DETERMINANTS
Financial leverage: refers to debt in a firjms cap. Structure. Any firm with debt- levered firm. There are fixed interests (financial FC) and cause in ebit Dfl = ( eps)/ ( ebit/ebit) As fl of a firm increases the e of firm also increases.

example
Standard & Poor's 500 Index (S&P 500) has a beta coefficient (or base) of 1. That means if the S&P 500 moves 2% in either direction, a stock with a beta of 1 would also move 2%. Under the same market conditions, however, a stock with a beta of 1.5 would move 3% (2% increase x 1.5 beta = 0.03, or 3%). But a stock with a beta lower than 1 would be expected to be more stable in price and move less

PORTFOLIO BETA
The beta of a portfolio is the weighted sum of the individual asset betas, According to the proportions of the investments in the portfolio. A measure of a portfolio's volatility. A beta of 1 means that the portfolio is neither more nor less volatile or risky than the wider market. A beta of more than 1 indicates greater volatility while a beta of less than 1 indicates less. Beta is an important component of the Capital Asset Pricing Model, which attempts to use volatility and risk to estimate expected returns. Example: if 50% of the money is in stock A with a beta of 2.00, and 50% of the money is in stock B with a beta of 1.00,the portfolio beta is 1.50.

PORTFOLIO BETA
Portfolio betas tend to be more stable than individual security betas. p = w1 1 + + wn n