Beta is a measure of the systematic risk of a security or a portfolio. It measures the sensitivity of the security to, the change in the return of the market portfolio it can also be measured as the non-diversifiable risk. It is used in the Capital Asset Pricing Model (CAPM), a model that is used to calculate the expected rate of return of a portfolio based on risk and the market return.
Beta is calculated through regression analysis where the expected return is regressed on the market return. The formula is used for calculating Beta is given as:
β = Cov(Rj, Rm)/ σm2
β= ρj*σm*σj/ σm2
β– Beta for a security
Rj– Required rate of return for a security
Rm– Market rate of return
σm2– Variance of the market
ρjm– Correlation coefficient of the security and the market
σm– Standard deviation of the market
σj– Standard deviation of the security
β value is generally taken as 1, which is the market risk if β value is greater than 1 then it is considered to be aggressive stock and if,the value is less than 1 then, β is considered to be a defensive stock. Βeta can also have a value of zero at this condition required date of return is equal to the risk-free rate of return. Negative β asset gives negative risk premium. It is priced to give an expected return below the risk-free rate and it does have market risk.
There are certain disadvantages of beta:
- Beta does not take into consideration the new information or changes in the company. For example, a pharmaceutical company with a defensive beta (value less than 1) enter into energy business; beta does not take into account the risk that the particular company took by entering into a new industry.
- Many stocks which are new to the market do not have a sufficient price history to establish a reliable beta.
- A beta measure of a single stock tends to change a lot with time and hence it is an unreliable measure for a single stock.
- Beta is helpful for investors to sell and buy stocks for a shorter period, but these are poor indicators for the future.