Beta risk helps determine the relation between individual <b><a href="http://www.kotaksecurities.com/home/" title="Share Price">share price</b></a> and the market price as a whole. It also helps you choose stocks depending upon your needs that may be risk free or high return investment. Learn the concept of Beta risk and how to calculate it with Kotak Securities – India’s largest <b><a href="http://www.kotaksecurities.com/aboutus/index.html" title="Stock Broker">Share brokerage</a></b> Firm
Beta Market Risk
BETA – Providing A Measure Of Market Risk
DEFINITION"The Beta Coefficient in terms of finance and investing is a measure of the systematic risk of a stock or portfolio. It quantifies relative volatility in relation to the overall market, which is defined as having a beta of 1".
INTRODUCTIONRisk is an inevitable part of the investment process and this is known toevery investor. Risks in stock market can be subdivided into two partssystematic risks and unsystematic risks. Unsystematic risks are specificcompany risks or risks which occur due to non-diversification in a portfolioand can be reduced by proper diversification of portfolio. Systematic riskson the other hand are market risks and depend on macroeconomic factorsand they cannot be reduced by diversification.Though we cannot reduce market risks or systematic risks but we can havea measure of these risks with the help of beta. With the help of beta wecan approximately tell how much a particular stock will move if we knowhow much the whole stock market is going to move. Thus, beta tells uswhat the volatility is in a particular stock with respect to movements inthe stock market. Beta is also referred to as financial elasticity orcorrelated relative volatility.
CALCULATIONBeta is calculated on historical basis with the help of historical returns on aparticular stock and historical returns on the stock market. The wholemethod consists of finding covariance between the market returns andstock returns and dividing it by the variance of market returns. It iscalculated with the help of the following formula: Where : ra measures the rate of return of the stock rp measures the rate of return of the portfolio Cov(ra,rp) is the covariance between the rates of return
HOW TO INTERPRET BETABy definition, the market itself has an underlying beta of 1.0, andindividual stocks are ranked according to how much they deviate from themarket. A stock that swings more than the market (i.e. more volatile) overtime has a beta whose absolute value is above 1.0. If a stock moves lessthan the market, the absolute value of the stocks beta is less than1.0.More specifically, a stock that has a beta of 2 follows the market in anoverall decline or growth, but does so by a factor of 2 meaning when themarket has an overall decline of 3% a stock with a beta of 2 will fall 6%.Higher beta stocks mean greater volatility and are therefore considered tobe riskier, but are in turn supposed to provide a potential for higherreturns, low-beta stocks pose less risk but also lower returns. …… (continued)
HOW TO INTERPRET BETAIn the same way a stocks 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%. Also, if the beta of a stock is less than 1, such as 0.5, the stock will move at a rate of half of the market. For example, if the market increases by 10% the stock itself will increase only 5% and vice versa.
BETA – USES AND FACTS• Beta are calculated on historical prices thus it does not provide the exact picture for future and are backward looking• Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.• Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds. However, simply because a beta is zero does NOT mean that it is risk free. A beta can be zero simply because the correlation between that item and the market is zero. An example would be betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk free endeavor.• A negative beta simply means that the stock is inversely correlated with the market. Many precious metals and precious-metal-related stocks are beta-negative as their value tends to increase when the general market is down and vice versa.• FMCG, Pharmaceutical stocks are thought to be less affected by cycles and usually have lower beta. Reality and infrastructure stocks have higher beta and are more risky.
BETA - Criticisms• Past price fluctuations cannot completely describe the risk in a security as past fluctuation cannot give exact picture of future.• Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments.
CONCLUSIONThe reality is that past security price volatility does not reliably predictfuture investment performance (or even future volatility) and thereforebeta is not the perfect measure of risks but it helps you to analyze in abroad range how much your stock returns can deviate and it is also anintegral part capital asset pricing theory which is used to calculaterequired returns on a stock.
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