Tavagapedia

Beta

Key Takeaways

  • Beta denotes the inherent systematic risk or volatility in security or group of securities
  • The beta value of 1 indicates the security has the same volatility as the market. 

What is Beta?

Beta denotes the inherent systematic risk or volatility in security or group of securities. It measures the sensitivity of a financial instrument’s performance against the overall broad market performance.

Source: Tavaga

 What does beta describe?

If the beta of an asset is more than 1, it means the asset is more volatile than the broad market. If the beta is less than 1, the security is less volatile than the market. The value of 1 denotes security has the same volatility as the market. 

If the broad market gave returns of 10 percent, and the beta of the asset is 1.2, the returns on the asset will be 12 percent (10*1.2).

Beta is used with the CAPM, which is a pricing model using only a single factor. The security market line (SML) is a graphical representation of the CAPM with beta.

Example of Beta in CAPM

Let us solve an example to understand the use of beta in CAPM better. Let’s say that the risk-free rate is 5%, and the value of the expected market rate of return is 14%. There are two securities having two different values of beta. One security has a beta value of 0.5, and another has beta equal to 1.5.

Expected rate of return of the security can be calculated as:

Expected Return of security with beta equal to 0.5 = Risk free rate of return + β (Market Return – Risk free rate of return)

                                           = 5+0.5(14-5) = 9.5%

Expected Return of security with beta equal to 1.5 = Risk free rate of return + β (Market Return – Risk free rate of return)

                                                              = 5+1.5 (14-5) = 18.5%

Using R-squared for Beta

R-squared denotes the portion of a security’s historical price fluctuation that can be explained by the fluctuations in the benchmark index. If a stock is being compared to the right benchmark, then the value of R-squared will be high. A high value of R-squared ensures that the stock is getting compared with the right benchmark.

Limitations of Beta

While beta provides crucial information stock valuation, it has few shortcomings as well. It is useful if one wants to determine short term risk of a security and analyze the volatility to find out equity cost using CAPM. However, as beta uses historical data points, it becomes less promising for investors who want to look at a stock’s future movements. Also, it does not incorporate any new information regarding the stock, market, or portfolio for which it is used.