Understanding Beta 

The fundamental valuation of an asset to estimate intrinsic value, using free cash flow model to estimate the value. To know more about valuation, refer to the course on Introduction to Valuation on The middle Road. This lesson discusses the risk, it’s imperative to learn about the development of single factor Capital Asset Pricing Model. William Sharpe (1964), Litner (1965) and Mossin (1966) are credited with the development of Capital Market Theory and Capital Asset Pricing Model, a critical underpinning to the portfolio theory.

Dr. Harry Markowitz is considered the father of modern portfolio theory. He published the paper Portfolio Selection in March 1952 issue of the Journal of Finance, a gamechanger for portfolio management. 

The premise of the portfolio theory is that investors make decisions on expected return and risk: i.e., variability of the portfolio. Variance is the measure of the risk of a portfolio, the higher the risk higher the expected return. Investors will need extra compensation for an additional unit of risk. There are various measures to capture risk example Sharpe ratio, the Treynor ratio. For this course, it’s good to have a basic understanding of concepts in statistics. Variance is the square of standard deviation. The CAPM is the model that you will be using in this course to quantify the cost of equity.

Understanding Beta 

Risk can be divided into diversifiable and non-diversifiable risks. Diversifiable risk is a firm inherent risk, a risk that can de be diversified using more securities in the portfolio. Firm risk is a unique risk pertinent to business and strategy risk. Non-diversifiable risk is a global macro risk example; recession and interest rate risk cannot be diversified. Capital Asset Pricing Model uses riskless assets with a market portfolio. Riskless assets have zero variance, government securities of advanced countries example the United States of short-term duration. Market Portfolio includes tradeable assets, both financial and real assets. Examples of financial assets are stocks, and bonds, while real assets include commodities, land, art, etc.

An in-depth understanding of CAPM in essential for the understanding of portfolio management. Beta measures systematic risk and can be calculated in various ways. One is by measuring the covariance with the benchmark index, another through regression analysis – regressing a company’s returns with that of the benchmark index. Yahoo finance and other online sources share the beta of companies example, Microsoft has a beta of 0.91 calculated for five years monthly. This means that the price of the stock is likely to increase by 91 percent if NASDAQ goes up by 100 percent or fall by 91 percent if NASDAQ falls by 100 percent. 

Beta is the covariance of a security with the benchmark index. Beta is what we are interested to discuss today. 

The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities.The index includes 500 leading companies and covers approximately 80 percent of available market capitalization. To know more about S&P 500 cleck the link below. 

https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overviewe.

CAPM= Risk free rate + Beta (Market Risk Premium)                                                 

R_{f =} Risk free rate. Risk free asset has zero variance and zero correlation with risky assets. There are two ways of using risk free rate. Usually, T bills or short-term yields are used but according to Aswath Damodaran in the textbook Investment Valuation it’s better to use treasury bonds for valuing long term projects or valuations. When calculating risk premium i.e., excess return over risk free rate, the duration of the term must be similar to that of treasury bonds. Bonds have interest, default and reinvestment risk it’s better to refer to Fixed Income Introduction online course on The middle Road. Many advanced countries have no default risk for their government securities, for countries with sovereign risk use the formula below.

Risk free rate in local currency = Government or Sovereign Bond Rate – Default Spread  

The sovereign rate is the yield of the bond.

• Beta measured against a market portfolio which includes all traded securities held in proportion to their market value.
• We are assuming no there are no transaction costs or private information.