ECONOMIC DETERMINANTS OF BETA

This paper analyses the key determinants of beta in the Indian industries. Beta which is
considered as a measurement of market risk is having significant impact on the portfolio
managers and investment analysts. Beta of the security i is defined as the contribution of
security i to the variance of the market portfolio as a fraction of the total variance of the
market portfolio. Capital asset pricing model (CAPM) which describes expected return-
beta relationship is very familiar expression to the practitioners. Beta is used invariably
by the practitioners in the decision making process. The cost of equity and thus economic
value added (EVA) of any company depends upon the beta of that company. Different
models employed by the analysts to value company depend upon the cost of equity and
thus beta of the company. Thus, incorrect and wrong estimation of beta will lead to
overvaluation or undervaluation of the company. Beta shows the sensitivity of a
security’s returns to the market returns. It simply shows how the security’s returns change
with the change in market returns. If the beta of the stock is greater than one, it is
considered as an aggressive stock or the risk of that stock is more than the average market
risk. If beta of the stock is less than one, it is considered as a defensive stock or the risk of
that stock is less than the average market risk. If beta is zero, it means risk-free
investment. The next question which needs to be answered is that whether impact of
change in market return on security’s return remains the same over time or beta changes
over time. Are betas stable? The other question of the concern is why the betas of two
companies are different?
If betas are not stable (or they are different for two companies), it means that there are
certain decision and non-decision variables which influence firm’s beta or cause inter-
firm variation in beta. This paper analyses the reasons for inter-firm variation in beta.
That is, why the beta of one firm is different from the beta of another firm. Secondly, if
the beta of a particular firm is changing over time, what are the different decision and
non-decision variables of the firm which bring variation in beta?
There are various studies which dealt with determinants of systematic risk or beta [Ball
and Brown (1969); Breaver, Kettler and Scholes (1970); Logue and Merville (1972);
Pettit and Wasterfield (1972); Gonedes (1973, 1975); Rosenberg and Mckibben (1973);
Mehcher (1974); Bildersee (1975); Beaver and Manegold (1975); Ben-Zion and Shalit
(1975); Thompson (1976); Ruland (1981); Hamada (1972); Hill and Stone (1980);
Chance (1982); Rubinstein (1973). Mohr (1985) analysed the relationship between
financial leverage and beta. Lev (1974) showed that there is positive relationship between
degree of operating leverage and systematic risk. Gahlon and Gentry (1982) and
Mandelker and Rhee (1984) analysed the impact of degree of operating and financial
leverages on beta. Chung (1989) considered intrinsic business risk as a real determinant
of beta.
This paper is divided into five sections. Section 1 deals with the theoretical framework
describing the different determinants of beta. Section 2 describes about the model applied
for empirical testing. Section3 deals with the methodology and the date base of the study.
Section 4 describes the empirical results and Section 5 gives concluding remarks.

1. Theoretical Framework:
The theoretical model developed by Chung (1989) has been extended in the present study
to find out the theoretical determinants of beta.
Assume:
E i ,t −1 : the value of equity of firm i at the end of time period t-1,
S i ,t : the sales revenue of firm i during the time period t,
N i ,t : the net profit of firm i during the time period t,
Oi ,t : the operating income of firm i during the time period,
N
E m ,t −1 = ∑E i ,t −1 : the value of equity of all the firms of the economy at the end of the
1
period t-1,

N
S m ,t = ∑ S i ,t : the value of sales revenue of all the firms of the economy during the
1
period t,
N
N m ,t = ∑ N i ,t : the net profit earned by all the firms of the economy during the time
1
period t,
N
Om ,t = ∑Oi ,t : the operating income earned by all the firms of the economy during the
1
time period t.
Beta of the security i is defined as the sensitivity of the security i return to the market
return. Here, return on equity of the firm is taken as the measurement of the firm’s
security return. Return on equity earned by all the firms of the economy together is taken
as the measurement of the market return. That is, beta of the firm i, βi ,t , is defined as
follows:
Cov ( Ri ,t , Rm ,t )
βi ,t =
Var ( Rm ,t )
Where:
N i ,t
Ri ,t = : the return on equity earned by firm i during time period t,
E i ,t −1
N m ,t
R m ,t = : the return on equity of the market during time period t.
E m ,t −1
N i ,t N m ,t 1
Cov ( , ) Cov ( N i ,t , N m ,t )
E i ,t −1 E m ,t −1 E i ,t −1 E m ,t −1 E m ,t −1Cov ( N i ,t , N m ,t )
βi ,t = = =
N m ,t 1 E i ,t −1Var ( N m ,t )
Var ( ) 2
Var ( N m ,t )
E m ,t −1 E m ,t −1
N i ,t −1
Cov ( N i ,t , N m ,t ) = [Cov ( N i ,t , N m ,t ) − Cov ( N i ,t −1 , N m ,t )] [Since
N i ,t −1
Cov ( N i ,t −1 , N m ,t ) = 0 ]
 N i ,t −1 dN i ,t
Cov ( N i ,t , N m ,t ) = [Cov ( N i ,t − N i ,t −1 , N m ,t )] = N i ,t −1Cov ( , N m ,t )
N i ,t −1 N i ,t −1
dN i ,t Oi ,t −1 dO i ,t S i ,t −1 dS i ,t
Cov ( N i ,t , N m ,t ) = N i ,t −1Cov ( , N m ,t )
N i ,t −1 Oi ,t −1 dO i ,t S i ,t −1 dS i ,t

dN i ,t Oi ,t −1 dO i ,t S i ,t −1 dS i ,t
Cov ( N i ,t , N m ,t ) = N i ,t −1Cov ( , N m ,t )
dO i ,t N i ,t −1 dS i ,t Oi ,t −1 S i ,t −1
dN i ,t Oi ,t −1
=the degree of financial leverage of firm i ( DFL i ,t )
dO i ,t N i ,t −1
dO i ,t S i ,t −1
= the degree of operating leverage of firm I ( DOL i ,t )
dS i ,t Oi ,t −1
dS i ,t
Cov ( N i ,t , N m ,t ) = N i ,t −1 DFL i ,t DOL i ,t Cov ( , N m ,t )
S i ,t −1
dS i ,t dS i ,t
Cov ( , N m ,t ) = Cov ( , ( N m ,t − N m ,t −1 ))
S i ,t −1 S i ,t −1
dS i ,t dS i ,t dN m ,t
Cov ( , N m ,t ) = N m ,t −1Cov ( , )
S i ,t −1 S i ,t −1 N m ,t −1
dS i ,t dS i ,t dN m ,t S m ,t −1 dS m ,t
Cov ( , N m ,t ) = N m ,t −1Cov ( , )
S i ,t −1 S i ,t −1 N m ,t −1 S m ,t −1 dS m ,t
dS i ,t dS i ,t dN m ,t S m ,t −1 dS m ,t
Cov ( , N m ,t ) = N m ,t −1Cov ( , )
S i ,t −1 S i ,t −1 dS m ,t N m ,t −1 S m ,t −1
dN m ,t S m ,t −1
= the degree of the total leverage of the market ( DTL m ,t )
dS m ,t N m ,t −1
dS i ,t dS i ,t dS m ,t
Cov ( , N m ,t ) = N m ,t −1Cov ( , DTL m ,t )
S i ,t −1 S i ,t −1 S m ,t −1
dS i ,t dS i ,t dS m ,t
Cov ( , N m ,t ) = N m ,t −1 DTL m ,t Cov ( , )
S i ,t −1 S i ,t −1 S m ,t −1
dS i ,t dS m ,t
Cov ( N i ,t , N m ,t ) = N i ,t −1 N m ,t −1 DFL i ,t DOL i ,t DTL m ,t Cov ( , )
S i ,t −1 S m ,t −1
Var ( N m ,t ) =Var ( N m ,t − N m ,t −1 )
Var ( N m ,t ) =Var ( dN m ,t )
dS m ,t S m ,t −1
Var ( N m ,t ) = Var ( dN m ,t )
dS m ,t S m ,t −1
dN m ,t S m ,t −1 dS m ,t
Var ( N m ,t ) = N 2 m ,t −1Var ( )
dS m ,t N m ,t −1 S m ,t −1
dS m ,t
Var ( N m ,t ) = N 2 m ,t −1Var ( DTL m ,t )
S m ,t −1
 dS m ,t
Var ( N m ,t ) = N 2 m ,t −1 DTL 2
m ,t Var ( )
S m ,t −1
E m ,t −1Cov ( N i ,t , N m ,t )
βi ,t =
E i ,t −1Var ( N m ,t )
dS i ,t dS m ,t
Cov ( , )
N i ,t −1 / Ei ,t −1 DFL i ,t DTL i ,t S i ,t −1 S m ,t −1
βi ,t =
N m ,t −1 / E m ,t −1 DTL m ,t dS m ,t
Var ( )
S m ,t −1
dS i ,t
= growth rate in demand of firm i ( GD i ,t )
S i ,t −1
dS m ,t
= growth rate in demand of the entire market ( GD m ,t )
S m ,t −1
DTL m ,t = DFL m ,t DOL m ,t

N i ,t −1
= return on equity earned by firm i during the period t-1 ( Ri ,t −1 )
E i ,t −1
N m ,t −1
= return on equity earned by the entire market during the period t-1 ( Rm ,t −1 )
E m ,t −1

Ri ,t −1 DFL i ,t DOL i ,t Cov (GD i ,t , GD m ,t )

βi ,t =
Rm ,t −1 DFL m ,t DOL m ,t Var (GD m ,t )
Ri ,t −1 DFL i ,t DOL i ,t
βi ,t = β GD i ,t
Rm ,t −1 DFL m ,t DOL m ,t
Where β GD i ,t is the beta of growth rate in demand of firm i during the period t which
measures the sensitivity of the growth rate in demand of firm i to the growth rate in
market demand.
Thus, the systematic risk of the common stock of firm i during the current year is a
function of the ratio of return on equity of firm i in the previous year to the return on
equity of the entire market in the previous year, the ratio of the degree of financial
leverage of firm i during the current year to the degree of financial leverage of the entire
market during the current year, the ratio of degree of operating leverage of firm i during
the current year to the degree of operating leverage of the entire market during the current
year and the demand beta during the current year, which measure the demand volatility of
the firm’s output to the general economic conditions.
If the firm’s return on equity, degree of operating leverage and degree of financial
leverage are respectively equal to return on equity, degree of operating leverage and the
degree of financial leverage of the entire market (that is,
Ri ,t −1 = Rm ,t −1 ; DFL i ,t = DFL m ,t andDOL i ,t = DOL m ,t ) , the demand beta is the source
of riskiness of the common stock. The demand beta may be taken as the measurement of
the intrinsic business risk of the firm in the market. The results are different from that of
Chung (1989) which shows that if the firm is both operationally and financially unlevered
(that, DOL = DFL =1), the demand beta represents the source of riskiness of the common
stock. The results of the present show that even if the firm is operationally and financially
levered, the demand beta may be sole source of riskiness of the common stock provided
that operational and financial risk of the firm is the same as that of the entire market.
Thus, even if the firm is both operationally and financially unlevered, the demand beta
may not be the sole determinant of systematic risk of the common provided that the entire
market is operationally and financially levered.