It measures non-diversifiable risk. Beta shows how the price of a security responds to market forces. The more responsive the price of a security is to changes in the market, the higher will be its beta. Beta is calculated by relating the returns on a security with the returns for the market. The beta for the overall market is equal to 1.00 and the market return is measured by the average return of a large sample of stocks.
- If the beta is more than1, it is more sensitive to the market or systematic risk than the average investment.
- If the beta is 1, then it has the same risk profile as the market as a whole, the average risk profile.
- If beta is less than 1, it is not as sensitive to systematic or market as the average investment. The beta factor is the correlation co-efficient between the returns on a market portfolio of investments and the returns on a particular stock or investment.
- Beta = +1.0: 1% change in the market index return causes exactly 1% change in the stock return. It indicates that the stock moves in tandem with the market.
- Beta = + 0.5: 1% change in the market index return causes exactly 0.5% change in the stock return. The stock is less volatile compared to the market.
- Beta = +2.0: 1% change in the market index return causes exactly 2% change in the stock return. The stock is more volatile when there is a decline of 10% in the market return, the stock with a beta of 2 would give a negative return of 20%. The stocks with more than a beta value of 1 are considered to be risky.
The beta factor is the correlation co-efficient between the returns on a market portfolio of investments and the returns on a particular stock or investment.
Calculation of Beta
The expected return of an individual security is equal to the risk free rate plus an additional amount for bearing systematic as measured by beta.
Rs=a + BsRm
Where
Rs = estimated return on the stock
a = estimated return when the market return is zero
Bs = measure of stock’s sensitivity to the market index
Rm = return on the market index
Illustration:
Star Finwest Ltd., a mutual fund manager having highly sensitive securities in his portfolio. Its return on securities will vary twice the average market returns. Suppose, if the market went up or down by 5%, then the returns on the securities of the above investor will increase or decrease by 10%. The beta factor of securities of the mutual fund investments is 2.0
Using Beta to Estimate Return
Capital Asset Pricing Model (CAPM) uses beta to link formally the notions of risk and return. CAPM was developed to provide a system whereby investors are able to assess the impact of an investment in a proposed security on the risk and return of their portfolio
CAPM is used to understand the basic risk –return tradeoffs involved in various types of investment decisions. The model is used to define the required return on security according to the following equation:
Rs = Rf + Bs(Rm-Rf)
Where
Rs = the return required on the investment
Rf = the return that can be earned on a risk free investment
Rm=the average return on all securities
Bs=the security’s beta (systematic)risk
