Definition of 'Beta'

The Beta coefficient (), in terms of finance and investing, is a measure of a stock's (or
portfolio's) volatility in relation to the rest of the market. Beta is calculated for individual
companies using regression analysis.
The beta coefficient is a key parameter in the capital asset pricing model (or CAPM).
It measures the part of the asset's statistical variance that cannot be mitigated by the
diversification provided by the portfolio of many risky assets, because it is correlated with
the return of the other assets that are in the portfolio.

Interpretations of Beta
Some interpretations of beta are explained in the following table:
Value of
Beta
<0
=0
0<<1

=1

>1

Interpretation
Asset generally moves in the
opposite direction as compared to
the index
Movement of the asset is
uncorrelated with the movement of
the benchmark
Movement of the asset is generally
in the same direction as, but less than
the movement of the benchmark

Example
An inverse exchange-traded fund or a
short position
Fixed-yield asset, whose growth is
unrelated to the movement of the stock
market
Stable, "staple" stock such as a
company that makes soap. Moves in
the same direction as the market at
large, but less susceptible to day-today fluctuation.
A representative stock or a stock that is
a strong contributor to the index itself.

Movement of the asset is generally

in the same direction as, and about
the same amount as the movement of
the benchmark
Movement of the asset is generally
Stocks which are very strongly
in the same direction as, but more
influenced by day-to-day market news
than the movement of the benchmark or by the general health of the
economy.

It measures the part of the asset's statistical variance that cannot be removed by
the diversification provided by the portfolio of many risky assets, because of
the correlation of its returns with the returns of the other assets that are in the portfolio. Beta
can be estimated for individual companies using regression analysis against a stock market
index.

There are several misconceptions about beta. Amongst the most common are:

Beta measures the relative volatility of a security's price compared to the price of
the market. Beta is a measure that compares returns, not prices; a security with a
positive beta can have a price that decreases while the market's price increases. The key is
whether the security's returns are above or below its mean return when the market's
returns are above or below its mean return; whether the security's mean return is positive
or negative is not relevant to its beta.

Beta measures the relative volatility of a security's returns compared to the

volatility of the market's returns. Beta has two components: relative volatility of
returns, and correlation of returns. Unless the correlation of returns is +1.0 or -1.0, beta
does not measure the relative volatilities of returns.

A positive beta means that a security's returns and the market's returns tend to
be positive and negative together; a negative beta means that when the market's
return is positive the security's return tends to be negative, and vice versa. The
calculation of beta involves deviations of the market's returns and the security's returns
about their respective mean returns. A security with a negative mean return can have a
positive beta, and a security with a positive mean return can have a negative beta.

A beta of 1.0 means that the security's returns have the same volatility as the
market's returns. This could be true, or the security's returns could be twice as volatile
as the market's returns, but their correlation of returns is +0.5. Beta, by itself, does not
describe the relative volatility of returns.

Applications of Beta
Beta is a commonly used tool for evaluating the performance of a fund manager. Beta is used
in contrast with Alpha to denote which portion of the fund's returns are a result of simply
riding swings in the overall market, and which portion of the funds returns are a result of
truly outperforming the market in the long term. For example, it is relatively easy for a fund
manager to create a fund that would go up twice as much as the S&P 500 when the S&P rose
in value, but go down twice as much as the S&P when the S&P's price fell - but such a fund
would be considered to have pure Beta, and no alpha. A fund manager who is producing
Alpha would have a fund that outperformed the S&P 500 in both good times and bad.
Beta can also be used to give investors an estimate on a stock's expected returns relative to
the market return. Consider some examples:

Company ABC, a tech stock, has a beta of 1.8. Over a given year, the NASDAQ
Composite Index increases in value 17%. Assuming the beta value is accurate, ABC's
value should have increased 30.1% or (1.8 x 17%) over the same time period.

Company XYZ, a mid-sized oil company, has a beta of 1.0. Over a given year,
the S&P 500 Index falls 8%. Assuming the beta value is accurate, XYZ's value would
also have fallen 8% over the same period.

Company LMN, a gold mining company, has a beta of -1.4. Over a given year,
the S&P 500 Index increases in value 11%. Assuming the beta value is accurate, LMN's
value would have declined 15.4% or (-1.4 x 11%) over the same period.
There are, however, significant disadvantages to beta.

1. Its calculated from historical data (and hence does not capture future changes in the
market), and of course depends on the chosen time period.
2. Beta does not discriminate between upwards volatility and downwards volatility.
3. It assumes that volatility is described by a normal distribution this isnt always the
case

Variances in Beta
Values of Beta can vary depending on how they are calculated. Specifically, the main varying
components are:

Different time frame: Depending on how far back into history the beta calculation
goes, the values will differ. For example, if one calculation includes the stock prices for
the trailing 12 months versus the trailing 60 months; the two values will be different.

Different time intervals: Depending on the interval between the stock prices used,
beta calculations can differ. For example, one calculation which uses the monthly stock
prices will differ from another calculation which uses weekly or daily stock prices.

Different index: Beta calculations can vary depending on which index is used to
measure the overall value in the market. For example, using the S&P 500 (.SPX-E) and
the Dow Jones Industrial Average (.DJIA) will result in different values.

Inclusion or exclusion of dividends: Depending on whether dividends are included

in the calculation of the returns of the stock, the beta calculations can differ.

The result of each of these different choices can cause beta values to differ widely depending
on how the calculation is made. This means that a beta value is not an exact value of how a
stock varies with the market, but a representation.
Statistical estimation

Beta is estimated by regression. Given an asset and a benchmark that we are interested in,
we want to find an approximate formula

where ra is the return of the asset and rb is return of the benchmark.

Since the data are usually in the form of time series, the statistical model is
,
where t is an error term (the unexplained return). Click here for a definition of Alpha ().
The best (in the sense of least squared error) estimates for and are those such that
t2 is as small as possible.
A common expression for beta is
,
where Cov. and Var. are the covariance and variance operators.
This can also be expressed as

Where a,b is the correlation of the two returns, and a and b are the respective
volatilities. Relationships between standard deviation, variance and
correlation:
Beta can be computed for prices in the past, where the data is known, which is historical
beta. However, what most people are interested in is future beta, which relates to risks
going forward. Estimating future beta is a difficult problem. One guess is that future beta
equals historical beta.
From this, we find that beta can be explained as "correlated relative volatility". This has
three components:
correlated
relative
volatility
Beta is also referred to as financial elasticity or correlated relative volatility, and can be
referred to as a measure of the sensitivity of the asset's returns to market returns, its nondiversifiable risk, its systematic risk, or market risk. On an individual asset level,

measuring beta can give clues to volatility and liquidity in the marketplace. In fund
management, measuring beta is thought to separate a manager's skill from his or her
willingness to take risk.
The portfolio of interest in the CAPM formulation is the market portfolio that contains all
risky assets, and so the rb terms in the formula are replaced by rm, the rate of return of the
market. The regression line is then called the security characteristic line (SCL).
is called the asset's alpha and
is called the asset's beta coefficient. Both coefficients
have an important role in modern portfolio theory.
For example, in a year where the broad market or benchmark index returns 25% above
the risk free rate, suppose two managers gain 50% above the risk free rate. Because this
higher return is theoretically possible merely by taking a leveraged position in the broad
market to double the beta so it is exactly 2.0, we would expect a skilled portfolio manager
to have built the outperforming portfolio with a beta somewhat less than 2, such that
the excess return not explained by the beta is positive. If one of the managers' portfolios
has an average beta of 3.0, and the other's has a beta of only 1.5, then the CAPM simply
states that the extra return of the first manager is not sufficient to compensate us for that
manager's risk, whereas the second manager has done more than expected given the risk.
Whether investors can expect the second manager to duplicate that performance in future
periods is of course a different question.
The SML graphs the results from the capital asset pricing model (CAPM) formula. The xaxis represents the risk (beta), and the y-axis represents the expected return. The market
risk premium is determined from the slope of the SML.
The relationship between and required return is plotted on the security market
line (SML) which shows expected return as a function of . The intercept is the nominal
risk-free rate available for the market, while the slope is E (Rm) Rf. The security market
line can be regarded as representing a single-factor model of the asset price, where Beta
is exposure to changes in value of the Market. The equation of the SML is thus:
It is a useful tool in determining if an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the SML graph. If
the security's risk versus expected return is plotted above the SML, it is undervalued
because the investor can expect a greater return for the inherent risk. A security plotted
below the SML is overvalued because the investor would be accepting a lower return for
the amount of risk assumed.

Example: You are given the following information about the market portfolio and
McWilliams Company:
State of nature

probability

Market return
R
( m )

McWilliams Equity Return

R
( i )

0.1

-0.15

-0.30

0.3

0.05

0.10

0.4

0.15

0.30

0.2

0.20

0.40

What is the beta of the McWilliams Company?

Calculation of market parameters
State of
nature (S)

Probability
(Ps)

Market return
(Rm)

1
2
3
4

0.1
0.30
0.04
0.20

- 0.15
0.05
0.15
0.20

Ps(Rm)

E(

-0.02
0.02
0.06
0.04
Rm

(Rm
R

( RmR m)2

Ps
(RmR m)2

m)

-0.25
-0.05
0.05
0.10

0.0625
0.0025
0.0025
0.0100

0.0063
0.0008
0.0010
0.0020
Var (Rm)=.01

= 0.10

Calculation of expected return and covariance of McWilliams Company

S

Ps

Ri

Ps(

Ri

Ri
R i )

(Rm- R

m)

(Rm- R m)

Ri

- Ri )

Ps (

Ri

- Ri )

(Rm- R m)

1
2
3
4

0.1
0.30
0.04
0.20

- 0.30
0.10
0.30
0.40

-0.03
0.03
0.12
0.08

E( Ri ) =

-0.50
-0.10
0.10
0.20

02

We know,

i.

Cov ( Ri , R m)
Var ( Rm)

0.125
0.005
0.005
0.020
Cov (

0.20

-0.25
-0.05
0.05
0.10

0.02
.01

= 2.0

0.0125
0.0015
0.0020
0.0040
Ri , R m

)=.