Beta
What is Beta?
A stock's beta describes how the stock has historically tracked against the
relevant index. A stock with a high beta will earn higher returns in a bull
market and higher losses in a bear market, while a lower beta stock will earn
lower returns in a bull market and lower losses in a bear market. Thus beta can
also be referred to as market risk, and stocks are often gauged on their
riskiness by using the Beta coefficient. The beta coefficient can be derived
from a linear regression of historical stock returns against an appropriate
market index. The beta concept also applies to investment portfolios, and the
portfolio beta can be derived by taking the weighted average of the betas of all
the stocks in the portfolio.
How does it relate to Markets?
The beta of a stock or investment is a critical concept in understanding the
risk and reward trade-off. It is also highly important in constructing
portfolios and executing investment strategies. For example the beta of a
portfolio can be manipulate via the use of short selling, including stocks with
differing betas, or through derivatives
e.g. options and futures. For example a portfolio that has a beta of 1 could be
hedged out to 0 through the selling of stock futures (selling a stock futures
contract results in a negative beta because the payoff from the futures contract
will be inverse to a long cash position in the stock or portfolio of stocks).
The beta is also a key input into the CAPM,
which is used to generate the expected return, and assess alpha.
Calculation
The beta coefficient can be calculated by running regressions on stock
returns and index returns. For example you may take daily returns of a stock
like Citigroup, or Bank of America, or Goldman Sachs, and regress those returns
against the daily returns of the S&P 500, using an OLS regression.
Sources and further reading:
Investopedia
- Calculating Beta: Portfolio Math for the Average Investor
Wikinvest - Beta
Index Universe - Asset Class Correlations: A Different Take
Scholes, M, & Williams, J. (1977) Estimating betas from nonsynchronous data.
Journal of Financial Economics, vol5, issue 3
Graph Library:
n/a
Original Source:
http://www.econgrapher.com/encyclopedia-beta.html
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