What Beta Means? (Page: 1 of 1)

Beta measures non-diversifiable risk. Beta shows how the price of a security responds to market forces. In effect, 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 other betas are viewed in relation to this value.

Betas can be positive or negative. However, nearly all betas are positive and most betas lie somewhere between 4 and 1.9.

The appropriate numbers and formulas that we must have for calculating beta is illustrated in the table given below:

Calculating Beta figure-6

The line that goes through the middle of the points in the graphic space is called the characteristic line. This line could be eyeballed by minimizing the spread of the data point above and the below the line. Use the proper math for describing the line is more accurate. The equation for the line is:

R_s = a + B_sR_m

Where:

R_s = estimated return on the stock
a = estimated return when the market return is zero
B_s= measure of stock's sensitivity to the market index
R_m = return on the market index.

CAPM (Capital Asset Pricing Model) uses beta to link formally the notions of the 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. We can use CAPM to understand the basic risk-return trade offs involved in various types of investment decisions. CAPM can be viewed both as a mathematical equation and, graphically, as the security market line (SML).

Using beta as the measure of non-diversifiable risk, the capital asset pricing model (CAPM) is used to define the required return on a security according to the following equation:

R_s = R_f + B_s (R_m - R_f)

Where:

R_s = the return required on the investment
R_f = the return that can be earned on a risk-free investment
R_m = the average return on all securities
B_s = the security's beta (systematic) risk.

It is easy to see that the required return for a given security increases with increases in its beta.

Application of CAPM can be demonstrated. Assume a security with a beta of 1.2 is being considered at a time when the risk-free rate is 4% and the market return is expected to be 12%. Substituting these data into the CAPM equation, we get:

R_s = 4% + [1.20 * (12% - 4%)] = 4% + [1.20 * 8%] = 4% + 9.6% = 13.6%

The investor should therefore require an 13.6% return on this investment as compensation for the non-diversifiable risk assumed, given the security's beta of 1.2. If the beta were lower, say 1.00, the required return would be 12% i.e. [4%+ [1.00 * (12%-4%)]]. CAPM reflects a positive mathematical relationship between risk and return, since the higher the risk (beta) the higher the required return.

When the CAPM is depicted graphically, it is called the Security Market Line (SML). Plotting CAPM, we would find that the SML is a straight line. It tells us the required return an investor should earn in the marketplace for any level of unsystematic (beta) risk.

SECURITY MARKET LINE figure-7