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Beta
Centre for Financial Management , Bangalore
Introduction
Financial assets are expected to generate cash flows and hence the riskiness of a financial asset is measured in terms of the riskiness of its cash flows. The riskiness of the asset may be measured on a stand alone basis or in a portfolio context. An asset may be very risky if held by itself but may be much less risky when it is part of a large portfolio.
In context of portfolio, the risk of an asset is divided into two parts unique risk and market risk.
Current yield
RATE OF RETURN
E(R) =
pi Ri i=1
(8.1)
E(R)= Expected return Ri = return for the ith possible outcome pi is the probablity associated with Ri n is the number of possible outcomes
0.5(11%)+(0.2)(6%)=11.5% Similarly, the expected rate of return on Oriental Shipping stock is: E(Ro) = (0.30) (40%) + (0.50) (10%) + (0.20) (-20%) = 13.0%
Standard deviation
For
measuring risk, standard deviation is used, as risk refers to dispersion of a variable from mean. In finance it is assumed that stock returns , at least over short intervals of time, are normally distributed. So, the mean and standard deviation contain all information about return and risk of the stock.
NORMAL DISTRIBUTION
Investors always prefer to invest in a portfolio of assets . So, what really matters is not risk and return on a single stock but the risk and return of the portfolio as a whole. Calculation of expected return of a portfolio of stocks:
If a portfolio consists of 3 securities with expected return s as E(R1)=10%, E(R2)= 15% , E(R3)= 20%
and the proportion invested in these securities= W1=0.3,W2=0.5,W3=0.2 So, Expected return of portfolio = 10x0.3+15xo.5+20x0.2=14.5% General formulae,
E(Rp) = wi E(Ri)
Stock A : 0.2(15%) + 0.2(-5%) + 0.2(5%) +0.2(35%) + 0.2(25%) = 15% Stock B : 0.2(-5%) + 0.2(15%) + 0.2(25%) + 0.2(5%) + 0.2(35%) = 15% Portfolio of A and B : 0.2(5%) + 0.2(5%) + 0.2(15%) + 0.2(20%) + 0.2(30%) = 15% Standard Deviation 2A = 0.2(15-15)2 + 0.2(-5-15)2 + 0.2(5-15)2 + 0.2(35-15)2 + 0.20 (25-15)2 = 200 A = (200)1/2 = 14.14% Stock B : 2B = 0.2(-5-15)2 + 0.2(15-15)2 + 0.2(25-15)2 + 0.2(5-15)2 + 0.2 (35-15)2 = 200 B = (200)1/2 = 14.14% Portfolio : 2(A+B) = 0.2(5-15)2 + 0.2(5-15)2 + 0.2(15-15)2 + 0.2(20-15)2 + 0.2(30-15)2 = 90 A+B = (90)1/2 = 9.49% Stock A :
Centre for Financial Management , Bangalore
Diversification of portfolio
But empirical studies show that diversification reduces risk but to some extent as as more and more securities are added , the risk decreases ,but at a decreasing rate, and reaches a limit
Studies also suggest that bulk of the benefit of diversification is achieved by forming a portfolio of 10 securities after which benefit of diversification becomes negligible.
Unique risk of a security represents that portion of its total risk which stems from company-specific factors like development of new product, labour strike,
emergence of new competitor. These risks can be washed away by combining different stocks which neutralizes the effects of such adversities. Thats why they are called as diversifiable risk or unsystematic risk .
Market risk of security represents that portion of its risk which is attributable to economy wide factors like GDP, inflation, interest rates etc.
Since these affect all firms to a greater or lesser degree , investors cannot avoid the risk arising from them, however , diversified their portfolios may be.
The measurement of market risk of a security is the most important concept in portfolio analysis.
Return on a risky security(Rr) is more volatile than the return on market portfolio(RM), whereas return on
Exhibit 8.8
Exhibit 8.8
Returns
Rc Rm Rr
Time
THE SENSITIVITY OF A SECURITY TO MARKET MOVEMENTS IS CALLED BETA . BETA MEASURES VARIABILITY OF RETURN ON A SECURITY WITH RESPECT TO CHANGES IN MARKET PORTFOLIO. Example: If beta of a security A is 1.5 , means if return on market portfolio is expected to increase/decrease by 10% the return on security A will increase/decrease by 15%(1.5x10%). if beta of security B is 0.8 , means if return on market portfolio is expected to increase /decrease by 10% , the return on B would increase/decrease by 8%. If beta of security is < 1 , defensive stock = 1, neutral stock > 1, aggressive stock
slope
, a= intercept
Security Return
Market return
Centre for Financial Management , Bangalore
CALCULATION OF BETA
For calculating the beta of a security, the following market model is employed: RA = a + b RM + e Or where RAt a R At = a + b R Mt + e = return of security A in period t = intercept term alpha = beta = return on market portfolio in period t = random error term
RM e
Beta reflects the slope of the above regression relationship. It is equal to:
Formulae
b=
r x A M Where _ _ r = (R R ) (R - R ) At A Mt M
n t=1
( n-1)x A x _ _ a = RA RM
CALCULATION OF BETA
Historical Market Data
Year 1 2 3 4 5 6 7 8 9 10 RA 10 6 13 -4 13 14 4 18 24 22 RM 12 5 18 -8 10 16 7 15 30 25 _ RA-RA -2 -6 1 -16 1 2 -8 6 12 10 _ RM-RM -1 -8 5 -21 -3 3 -6 2 17 12 _ _ (RA- RA) (RM-RM) 2 48 5 336 -3 6 48 12 204 120 778 r = 0.95 2M = 1022/9=113.6, 2A= 646/9=71.7 r = 778 = 0.95 9x 10.66 x 8.5 _ (RM-RM)2 1 64 25 441 9 9 36 4 289 144 1022
Beta : =
12 (0.76)(13) = 2.12%
Characteristic line
The values of Beta and alpha , Return on Market portfolio can be use to calculate the Return on security A. The graphic representation of relationship between RA and RM(exhibit 8.9) is called as characteristic line. The dispersion of data points around the characteristic line represents the diversifiable risk of the stock. The wider the dispersion of data points around the characteristic line, the greater the diversifiable risk and vice versa.
5 10 15 20 25 30 RM
10 5
5 10
Estimation period( 5 year period) Return interval( weekly or monthly) Market index( BSE Sensex and Nifty Index) Statistical precision
DETERMINANTS OF BETA Beta is mainly determined characteristics of the firm: by the following
Cyclicality of revenues
Operating leverage
Financial leverage
Cyclicality of revenues
Stocks of highly cyclical firms tend to have high betas. Variability is different from Cyclicality A firm with highly variable revenues need not have highly cyclical revenues and therefore need not have high beta.
Operating leverage
High operating leverage means high beta. High operating leverage stems from fixed costs.
FINANCIAL LEVERAGE
Debt equity = assets 1 +
Equity Thus, for a levered firm equity beta is always greater than the asset beta.
So far we ignored corporate taxes. As Robert Hamada has shown, the relationship between a firms asset beta and its equity beta, when corporate taxes exist, is: equity = assets Debt 1 + (1-Tax rate) Equity
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Capital structure composes of equity , preference and debt and this capital ,like any other factor of production ,has a cost . So, simply cost of capital is the average cost of various capital components employed by it. Put differently, company cost of capital is the average rate of return required by investors who provide capital to the company. Cost of capital is a central concept in FM and is used every where ( capital budgeting to price of product)
Some Preliminaries
Actually cost of capital is the WACC Suppose company uses Equity:Debt:Preference =50:40:10 and Cost of equity , preference and debt are 16%,12%and 8% respectively. WACC= 0.5(16)+0.10(12)+0.40(8)=12.4% Assumptions
Only three types of capital( equity; nonconvertible, noncallable
preference; nonconvertible and noncallable debt) are included. Debt includes both short term and long term Non interest bearing liabilities like Trade Creditors are excluded.
WACC
WACC
wp
rp
= proportion of preference
= cost of preference proportion of debt
wD =
Source of Capital
Proportion (1)
Cost (2)
Debt
Preference Equity
0.60
0.05 0.35
16.0%
14.0% 8.4%
9.60%
0.70% 2.94%
WACC
Derivative securities
Capital structure weights
COST OF EQUITY
Cost of equity is the return required by equity shareholders. Constitutes cost of retained earnings and cost of external equity. Though cost of external equity is some percentage higher than retained earnings , because of floatation costs involved. This difference will be discussed later. So, in our present discussion , the cost of equity refers to cost of retained earnings as well as cost of external equity.
COST OF EQUITY
by three scholars William Sharpe, John Lintner, Jack Treynor Bond yield plus risk premium approach Dividend discount model approach Earnings-price approach
CAPM Model
Most widely used risk return model CAPM predicts the relationship between risk of an asset and its expected return. Importance this model proves as a benchmark for evaluating various investments as when we analyze different securities we match the expected return from the return as per the CAPM model. It helps to calculate the expected return from a security which has not been traded in the market e.g pricing an IPO.
CAPM Model
Assumptions Investors are risk averse CAPM suggests that investors are compensated only for bearing the non diversifiable risk. Security returns are normally distributed Investors can borrow and lend freely at riskless rate of interest The market is prefect: there are no taxes, no transaction costs Market is competitive
CAPM Model
Simply to illustrate if , Stock j has beta of 1.4. If the riskfree rate is 10% and the expected return on market portfolio is 15%, the expected return on stock j = 10+ 1.4(15-10)= 17% By Formulae E(R j)= Rf + b j[ E(RM)- R f] Where E(R j) is the expected return on security j, Rf is the risk free rate of return E(RM) is the expected return on market portfolio b j is the beta of security j
Components of CAPM
The relationship also referred as Security Market line, consists of three components
Risk free rate Market risk premium beta
Components of CAPM
Risk free rate It is the return on a security (or portfolio of securities)that is free from default risk and is uncorrelated with returns from anything else in the economy. Theoretically the return on a zero-beta portfolio is the best example of risk-free rate which is complex and certainly difficult to calculate. Practically two alternatives are used: The rate on short term government security like the 364- days T-bill The rate on a long term government bond that has a maturity of 10 to 20 years.
Components of CAPM
Market Risk Premium It is the difference in the expected market return and the risk free rate Can be calculated by historical data or forward looking data Historical Risk premium It is the difference in the average return on stocks and the average risk free rate earned in the past Forward Risk Premium
It is again the difference b/w the expected market return and the
risk free rate But the expected market return is calculated as:
Components of CAPM
rate Example: dividend per share of stock A= 1.80 Current market price = Rs22 Earnings expected to grow at 6% So , Expected market return= 1.80/22+6=14.2%
PLOT SML
Assume Rf = 10% RM= 15% So if beta= 0.5 , then Rj= 10+0.5(1510)=12.5% If beta= 1.0 , then Rj = 10+1(15-10)=15% If beta= 1.5 , then Rj = 10+ 1.5(1510)=17.5%
Rate of Return
Rf = 10
0.5
1.0
1.5
2.0
Beta
Changes in SML
Inflation
If the inflation changes(increases or decrease) , the risk free rate
changes which will change the intercept of SML( exhibit 8.14 shows change in SML on increase in inflation) As earlier the risk free rate was 10% , but due to inflation it increases to 12% , So Rj,0.5=12+0.5(15-12)= 13.5 Rj,1.0= 12+1(15-12)=15 Rj,1.5=12+1.5(15-12)=16.5 So , the previous SML1 will shift to SML2
SML1
Inflation premium
Change in SML
If the risk aversion of investor changes , expected return will change and which will change the slope of SML The decrease in risk taking nature would obviously decrease the expected rate of return and thereby lessen the market risk premium (Exhibit 8.15)
SML1
SML2
Risk (Beta)
Pros Most widely use risk return model Gives an objective estimation of market risk premium which other approaches lack Its basic message that diversifiable risk does not matter is accepted by nearly everyone. Cons The study makes use of historical returns which cannot always represent the true picture. The study uses market index as a proxy for market portfolio but in real world market portfolio consists of all assets( financial ,real , as well human) and not just equity stocks.
So, rE =
P0
+g
Thus, the expected return of equity shareholders, which in equilibrium is also the required return, is equal to the dividend yield plus the expected growth rate. The expected growth rate ,g is difficult to calculate in this model . This model cannot be applied to companies that do not pay dividends or to companies that are not listed on stock exchange. This model does not takes into consideration the risk involved .
Earnings-Price Approach
According to this approach, the cost of equity is equal to : E1 / P0 where E1 = expected earnings per share for the next year P0 = current market price per share E1 may be estimated as : (Current earnings per share) x (1+ growth rate of earnings per share).
Floatation Costs
Floatation or issue costs consist of items like underwriting costs, brokerage expenses, fees of merchant bankers, and so on.
One approach to deal with floatation costs is to adjust the WACC to reflect the floatation costs: WACC Revised WACC = 1 Floatation costs
Tax rates
IMPLICATIONS
Diversification is important. Owning a portfolio dominated by a small number of stocks is a risky proposition.
While diversification is desirable , an excess of it is not. There is hardly any gain in extending diversification beyond 10 to 12 stocks. The performance of well diversified portfolio more or less mirrors the performance of the market as a whole. In a well ordered market, investors are compensated primarily for bearing market risk,but not unique risk. To earn a higher expected rate on return, one has to bear a higher degree of market risk.
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SUMMARY
Risk is present in virtually every decision. Assessing risk and incorporating the same in the final decision is an integral part of financial analysis. The rate of return on an asset for a given period (usually a period of one year) is defined as follows: Annual income + Ending price Beginning price Rate of return = Beginning price Based on the probability distribution of the rate of return, two key parameters may be computed: expected rate of return and standard deviation. The expected rate of return is the weighted average of all possible returns multiplied by their respective probabilities. In symbols, E(R) = pi Ri
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Risk refers to the dispersion of a variable. It is commonly measured by the variance or the standard deviation. The variance of a probability distribution is the sum of the squares of the deviations of actual returns from the expected return, weighted by the associated probabilities. In symbols, 2 = pi (Ri R)2 Standard deviation is the square root of variance. The normal distribution is the most commonly used probability distribution in finance. It resembles a bell-shaped curve. The expected return on a portfolio is simply the weighted average of the expected returns on the assets comprising the portfolio. In general, when the portfolio consists of n securities, its expected return is: E(Rp) = wi E(Ri) If returns on securities do not move in perfect lockstep, diversification reduces risk.
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As more and more securities are added to a portfolio, its risk decreases, but at a decreasing rate. The bulk of the benefit of diversification is achieved by forming a portfolio of about 10 securities. The following relationship represents a basic insight of modern portfolio theory: Total risk = Unique risk + Market risk The unique risk of a security represents that portion of its total risk which stems from firm-specific factors. It can be washed away by combining it with other securities. Hence, unique risk is also referred to as diversifiable risk or unsystematic risk. The market risk of a security represents that portion of its risk which is attributable to economy-wide factors. It is also referred to as systematic risk (as it affects all securities) or non-diversifiable risk (as it cannot be diversified away). The market risk of a security reflects its sensitivity to market movements. It is called beta.
Centre for Financial Management , Bangalore