Question

Explain 1) the factors that determine a security’s beta and 2) how asset beta relates to equity beta.

Answer 1

Beta describes the activity of a security's returns responding to swings in the market. A security's beta is calculated by dividing the product of the covariance of the security's returns and the market's returns by the variance of the market's returns over a specified period. Beta is useful in determining a security's short-term risk, beta relies on historical data, it doesn't factor in any new information on the market, stock or portfolio for which it's used. Factors that determine a security’s beta are:

1) The nature of business

2) The operating leverages

3) The financial leverages

Asset beta relates to Equity beta

The asset beta (unlevered beta) is the beta of a company on the assumption that the company uses only equity financing. In contrast, the equity beta (levered beta, project beta) takes into account different levels of the company's debt. A company has one asset beta and, depending on its debt-to-equity ratio, it can have many different equity betas. Asset Beta measures how volatile the underlying business is without considering capital structure. You calculate asset beta by removing the capital structure impact on the equity beta. Asset beta is also frequently refered to as unlevered beta. This is important as it allows investors to find an optimal capital structure by finding the average asset beta of industry and then taking the average asset beta of the industry and then "re-levering" it with the target company's capital structure with the following equation.

This beta allows investors to compare the relative volatility of assets stripping out the effect of capital structure choices

Formula                   βA=βE/1+(1−t)×DE

βA – asset beta,

βE – equity beta,

D – market value of debt,

E – market value of equity

t – marginal tax rate.