Estimating Security Betas

Risk and Return We know that investors demand a premium for bearing risk, i.e., the higher the riskiness of a security, the higher its expected return must be to induce investors to buy or hold. Within the context of MPT, part of the risk that can be eliminated by forming diversified portfolios is called unsystematic or diversifiable risk, while the part that cannot be eliminated is called systematic or market risk. If investors are concerned with the riskiness of their portfolios, rather than the risk of individual securities in the portfolio, how should the risk of an individual stock be measured? The CAPM provides a framework to analyze the relationship between risk and rate of return. The relevant risk of an individual stock is its contribution to the riskiness of a well-diversified portfolio.
SML Equation : Ri = R f + i ( Rm R f )

The risk that remains after diversifying is market risk, which can be measured by the degree to which a stock tends to move up or down with the market as reflected in its beta coefficient. The beta for an individual asset is derived from a regression model (single index model) by regressing stock returns against market returns. Single Index Model : Ri = i + i Rm + ei where i = i = Rm = ei = Intercept of the regression line Slope of the regression line (stock's sensitivity to market movement) Return on a proxy for the market portfolio Firm specific or unsystematic component of risk

The betas are standardized around 1 (market beta = 1). Beta = 1 (average risk investment); Beta > 1 (above average risk); Beta < 1 (below average risk); Beta = 0 (risk-less investment). The Basic Steps for Beta Estimation 1. Decide on the estimation period: Most of the financial services use periods ranging from 2 to 5 years for the regression. Decide on a return interval - daily, weekly, or monthly: Shorter intervals result in more observations, but suffer from noise created by stocks not trading. Estimate stock return: Return = (Price end - Price beginning + Dividends period)/Price beginning . Alternatively, the compound rate of return for the stock can be computed as: LN(Pend/ Pbeginning).

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Estimating Security Betas

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Choose an index as a proxy for the market and estimate returns for the index for each interval during the estimation period. A wide variety of indexes are available including the S&P 500, NYSE, etc. Most investigators use the S&P 500 composite index (its ticker symbol is ^GSPC) as a proxy for the market portfolio because this index encompass a large proportion of the total market value of US stocks. Collect price data for the stock and the selected index for the estimation period from the Internet. The monthly price data in the examples below was obtained from the Yahoo finance site (http://finance.yahoo.com/). Other sites may be used as well. Enter the ticker symbol of the company [Walt Disney (DIS), Bristol Myers Squibb (BMY)], get the Basic quote, then look at More Info box and click on Chart. When the graph for the firm's prices appears, look down at the bottom you will see the link - Historical Quotes. Select the time period (Jan 1, 1997 - Jan 1, 2002 is used in the examples) and interval (monthly). You should have 61 monthly observations. Download the prices to your computer disk in the Excel format. Do the same for the S&P 500 using matching interval and periods. Create a separate worksheet with date, S&P Close values, and stock adjusted close prices. Now compute monthly returns or percentage changes in prices using: LN(Pend/ Pbeginning) for both the stock and the index. Run regression in Excel to calculate the coefficient estimates for the single index model by regressing monthly stock returns (the Y in regression is the dependent variable) against percentage change in the index (the market is X or the independent variable). You can estimate the regression coefficients either using the appropriate Excel function keys or by using Regression facility of Data Analysis (Tools/Data Analysis/Regression). The use of Data Analysis is recommended because it produces a comprehensive regression output. Evaluate the regression output with special attention to model fit (F-value, R2) and statistical significance of the estimates. The R2 of the regression provides an estimate of the proportion of risk (variance) of a stock that can be attributed to market risk; the balance (1 - R2) can be attributable to firm specific risk.

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Examples The following example demonstrate estimation procedure for two companies, Walt Disney (DIS) and Bristol Myers Squibb (BMY), using monthly returns, S&P 500 as a proxy for market, and a five-year period. Only partial data are presented in the tables followed by regression outputs from Excel.

Estimating Security Betas

S&P 500 and Walt Disney Monthly Price and Return Data January 1, 1997 to January 2, 2002 S&P 500 Close
1130.20 1148.08 1139.45 1059.78 1040.94 1133.58 1211.23 1224.38 1255.82 1249.46 1160.33 1239.94 1366.01

Date
2-Jan-02 3-Dec-01 1-Nov-01 1-Oct-01 4-Sep-01 1-Aug-01 2-Jul-01 1-Jun-01 1-May-01 2-Apr-01 1-Mar-01 1-Feb-01 2-Jan-01

DIS Adj. Close

21.06 20.72 20.26 18.39 18.42 25.16 26.07 28.59 31.29 29.93 28.30 30.62 30.13

Return (MKT)
-0.01570 0.00755 0.07248 0.01794 -0.08526 -0.06626 -0.01080 -0.02535 0.00508 0.07401 -0.06636 -0.09683 0.03405

Return (DIS)
0.01628 0.02245 0.09684 -0.00163 -0.31182 -0.03553 -0.09227 -0.09024 0.04444 0.05600 -0.07879 0.01613 0.05107

1-Jan-97

60 0.0060 0.0517

60 -0.0017 0.0958

Count (number of observations) Average Monthly Return Standard Deviation of Return

Regression Output: Summary

Regression Multiple R R Square Adjusted R Square Standard Error Observations ANOVA Regression Residual Total df 1 58 59 SS 0.14502 0.39654 0.54156 MS F Significance F 0.14502 21.21179 0.00002 0.00684 Statistics 0.51748 0.26779 0.25516 0.08269 60

Intercept Market Return (Rm)

Coefficients Standard Error t Stat P-value -0.00753 0.01075 -0.70012 0.48665 0.95955 0.20834 4.60563 0.00002

Estimating Security Betas