Finding Value in Beta Risk Assessment

In finance, beta risk is a comparison of the volatility of a stock or security, in comparison to the market as a whole. The market as a whole is said to have a beta of 1.0. If an individual security has a beta below 1, it is thought to be less volatile than the market. The same is true with the other side of the scale, a stock with a security with a beta higher than 1 is considered volatile.

Calculating Beta

The formula for the beta coefficient of an asset seems complicated, but it can be broken down into parts that make it easier to understand.

  • Beta = Covariance of the rate of return of the asset versus the rate of return of the market / variance of the rate of return of the market

If you are attempting to determine the beta coefficient of an asset within a portfolio, you can simply substitute the rate of return of the portfolio for the rate of return of the market. To find covariance and variance, you can use a financial calculator.

Applying Beta to the CAPM

Beta is widely used in the Capital Asset Pricing Model (CAPM). This model attempts to determine what the actual value of an asset is based on its relative return, and relative risk, on the market. If the asset is priced lower than this theoretical value, the asset is though to be a good buy. In this formula, the expected return on the capital asset is equal to:

  • The risk-free rate of interest + Beta * (risk premium)

Here, risk premium is the difference between the expected market rate of return and the risk free rate of return. The CAPM is not an exact model. However, it does provide some relative price for an asset based on an estimate of its expected return.

Practical Applications of a Beta Risk Assessment

As a day-to-day investor, you can benefit from the beta risk assessment far more than other measures of risk. First, the beta risk assessment can be carried out with a very simple formula in a financial calculator. Unlike other models, such as the arbitrage price or the Farma-French model, there are only a few variables in the beta risk assessment. With limited information on the asset, a moderately knowledgeable investor could carry out the beta risk analysis without the help of a professional.

Beta risk assessment is simple and provides key insight into the value of an asset because it is a comparison. Even if the model is not perfect, since it is applied equally to each asset for comparison, it shows a relative value between two options. If you are considering adding a security to your current portfolio, you can simply assess the security's relative risk when compared to the risk of your existing portfolio.

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