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Monday, May 4, 2009

Investing

By definition, the market itself has an underlying beta of 1.0, and individual stocks are ranked according to how much they deviate from the macro market (for simplicity purposes, the S&P 500 is usually used as a proxy for the market as a whole). A stock that swings more than the market (i.e. more volatile) over time has a beta whose absolute value is above 1.0. If a stock moves less than the market, the absolute value of the stock's beta is less than 1.0.

More specifically, a stock that has a beta of 2 follows the market in an overall decline or growth, but does so by a factor of 2; meaning when the market has an overall decline of 3% a stock with a beta of 2 will fall 6%. Betas can also be negative, meaning the stock moves in the opposite direction of the market: a stock with a beta of -3 would decline 9% when the market goes up 3% and conversely would climb 9% if the market fell by 3%.

Higher-beta stocks mean greater volatility and are therefore considered to be riskier, but are in turn supposed to provide a potential for higher returns; low-beta stocks pose less risk but also lower returns. In the same way a stock's beta shows its relation to market shifts, it also is used as an indicator for required returns on investment (ROI). If the market with a beta of 1 has an expected return increase of 8%, a stock with a beta of 1.5 should increase return by 12%.

This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using the Capital Asset Pricing Model (CAPM). According to the model, the expected return on equity is a function of a firm's equity beta (βE) which, in turn, is a function of both leverage and asset risk (βA):

$K_{E} = R_{F} + \beta_E (R_{M} - R_{F} \frac{}{})$

where:

• KE = firm's cost of equity
• RF = risk-free rate (the rate of return on a "risk free investment", e.g. U.S. Treasury Bonds)
• RM = return on the market portfolio
• $\beta_E = \beta =\left[ \beta_A - \beta_D \left(\frac {D}{V}\right) \right] \frac {V}{E}$

because:

$\beta_A = \beta_D \left(\frac {D}{V}\right) + \beta_E \left(\frac {E}{V}\right)$

and

Firm Value (V) = Debt Value (D) + Equity Value (E)
An indication of the systematic riskiness attaching to the returns on ordinary shares. It equates to the asset Beta for an ungeared firm, or is adjusted upwards to reflect the extra riskiness of shares in a geared firm., i.e. th Geared Beta.