Stock beta and Volatility

Stock Beta and Volatility by Yukiko Griffin MBA 6160 Foundations of Financial Management

Stock beta and Volatility

Abstract The purpose of this paper is to understand the concept of a beta for a stock and its significance on investing. Firstly the paper explains the concept of a measurement of a beta value. Secondly, it explains CAPM theory and stock betas. Finally, it suggests that what we need to consider when we use a beta to measure volatility. Introduction Do you want to lose your money on investment? Nobody wants to take a loss on their investments. Some people like to use their money for a stock with low volatility. Some people are willing to take on additional risk because of the higher chance to increase the reward. Then how do they choose the stocks that they are willing to invest? The most famous way is the stocks beta. Beta is a very popular measurement of the market relative risk for a stock. In this research paper, we seek to understand what beta is and its significance in investing. Stock beta and Volatility Beta is a measure of individual stock risk or volatility to the overall risk of the stock market. It is calculated by using regression analysis. The general market is said to have a beta of 1.0. An individual stocks beta is measured to compare to this baseline of 1.0. A beta, 1.0 indicates the securitys price tends to be more volatile than the market, and a beta, 1.0 indicates that it tends to be less volatile than the market. For example, Apple Companys stocks beta is 1.35. The beta 1.35 means that Apple is 0.35 times more volatile than the general market. If the stock has a beta of 0.65, it means 0.35 times less volatile than the general market. Increased volatility of stock means more risk to the investors. However, that means they expect

Stock beta and Volatility

greater returns from stocks with betas over 1.0. If a stocks beta is less than 1.0, then they expect less volatility, lower risk, and lower overall returns. Beta is a key component for the capital asset pricing model (CAPM). CAPM is a model that attempts to price or value an individual security or portfolio. By using the following CAPM formula we can calculate the expected rate of return on an investment as: Expected Rate of Return=rf+ (rm-rf) Where: rf is the Risk Free Rate which is the interest rate the investor would expect to receive from a risk-free investment. is the Beta which measures the market risk. rm is the Expected Market Return which is the return the investor would expect to receive from a broad stock market indicator such as the S&P 500. For example, if a stock has 3% rate of return, 1.35 beta, and 9.4% average total return per year from 1900 to 2011, the equation is: Expected Rate of Return= (3%) +1.35(9.4%-3%) =11.64% The percentage, 11.64% tells that the stock needs to return 11.64% per year for it to be worth the risk to be invested. According to CAPM, Investors should be compensated for their money and the risk involved. If the expected return on the investment is less than the actual return, then it might not a wise investment.

Stock beta and Volatility

Beta is a good method for determine whether or not an investment is worth pursuing. However, there are some problems. Beta is calculated based on historical price movements. It doesnt mean the past beta or volatility predict accurate future beta or future volatility. Because the measure of them depends on historical prices, and it is impossible to calculate accurately the beta of newly issued stocks. Beta is a measurement of the risk that the market as a whole faces. It gives you a good idea how changes in the market affect the stock because it is found by comparing the volatility of the stock to the market index ,and it takes into account the effects of market-wide risks on the stock. However, it does not look at all the risks that a firm faces. Beta also does not distinguish bearish and bullish trends, or between large upswing or downswing movements. Thus while beta can tell something about the past risk of a security, it tells very little about the attractiveness or the value of the investment today or in the future. Beta is easy for all traders and investors to apply and helpful in finding right trading instruments. By using beta to measure volatility, investors can choose a stock that meets their criteria for risk. The investors who are willing to take on risk might want to choose a stock with higher beta and investors who take on high risk on their investment dont might choose a stock with lower beta. There are some disadvantages with relying on beta scores alone for determine the risk of an investment. You can use a beta for a short-term decision-making to measure volatility. If you want to buy and sell in a short- time period, stock beta is very useful tool to measure a risk. However, if you want to use only a stock beta to measure a risk for a long-term investment, there are so many flaws. If you want to invest for a long time, it is better to consider a companys fundamentals.

Stock beta and Volatility

References Investovedia Staff (2005, July 29). Beta: Gauging Price Fluctuations. Investovedia. Retrieved on June 2, 2012 from, http://www.investopedia.com/articles/01/102401.asp Little K. Using and Misusing the Beta Ratio. About.Com. Stocks. Retrieved on June 2, 2012 from, http://stocks.about.com/od/evaluatingstocks/a/beta120904.htm McClure B. (2004, November 30). Beta: Know The Risk. Investovedia. Retrieved on June 2, 2012, from, http://www.investopedia.com/articles/stocks/04/113004.asp Whistler, M. How to Use Implied Volatility (Beta) as an Options Volatility Meter. Mt. Vernon Research. Retrieved June 2, 2012 from http://www.mtvernonoptionsclub.net/ppc/ splash_impliedvolatility.cfm?kw=XVVSO084#5_strategies