Question

What determines a firm's beta? Should firm management make changes to its beta? Be sure to consider the implications for the firm's investors using CAPM.

Answer 1

Beta coefficient is the measure of volatility of the return of a stock, vis-à-vis the market return. This ratio indicates the degree of change in return consequent to a given change in the market return (the return on bench mark index). A beta higher than 1 indicates that the stock is more volatile than the market. As a result, reaction in price of the stock to an unsystematic risk event will be greater than that of the market in general. Reverse is the case of beta less than 1.

Beta is the integral part of Capital Asset Pricing Model (CAPM) which measures expected return of the stock using the volatility and market return along with risk free rate of return. As per CAPM,

Re= R_f + β(R_m-R_f)

Where Re= Expected return on the stock, β= the beta co-efficient, R_m= Expected return on the market and R_f= risk free rate of return.

Beta is calculated by dividing the co-variance between the share return and the market, by the variance of market return.

Firm’s management shall not change the beta. It is a ratio received as the product of stock performance in comparison with the market.

For investors, beta is useful in evaluating the expected return and price of the stock under consideration. Because, this method (CAPM) gives indication of likely short-term movements. However, this method, being purely based on past data, need not predict with the required degree of accuracy in the long run. Hence, investors need to consider other factors also. Another limitation is that Beta as a measure of risk is not accurate assumption since volatility measured could be in either direction. Also, this model assumes that risk free rate will remain unchanged over the discounting period which need not be correct. Investors should also realize that comparison, being with a large index as the market, might not reflect the real position with regard to the individual stock.