Graduating in Risk Premium

In case you have reached this vantage point after having understood the basics of 'risk premium', we offer you our hearty congratulations on having made such outstanding progress! Now, picking up the thread from where we left off, investors get compensated only for the market risk that they bear. Market risk is the only risk that cannot be reduced through diversification in your portfolio (by including a set of stocks from different businesses , like business risk can. !owever, the influence of the market varies for various stocks. "ome stock movements are e#aggerated compared with market movements while others are subdued. $e understood last time that the 'beta' of a stock measures this relative movement of a stock vis%&is the market. !ence, 'beta' measures the tendency of the stock to participate in the market movement. 'et's work this out using an e#ample... !yper 'td., (racker 'td. and "ober 'td. are three stocks that trade in the stock market of "hareland. "hare# is the stock market inde# in "hareland. !yper has a beta of ).* while (racker has a beta of ). +n the other hand, "ober has a beta of ,.-. .irst stop, what do these values mean& !yper's beta value of ).* indicates that it is far more sensitive to market movements than (racker and "ober. In other words, if the market as measured by "hare# goes up by ),/, !yper will go up by )*/. (racker will go up as much as the market, i.e. ),/, while "ober gains a mere -/ in relation to the market.

$ho commands the lower risk premium& 0fter having come so far in the lesson, we e#pect that you will flip this situation to its negative face and look at the situation when the stock market in "hareland drops by ),/. In this case, !yper drops the most (by )*/ as it has a higher beta of ).*. "ince (racker has a beta of ), it drops by ),/, the same as the market. +n the other hand, "ober drops by a mere -/. 0 higher beta means higher risk and hence a stock with higher risk needs to command a higher 'risk premium'. 0nd obviously, since !yper reacts in a manner true to its name for every drop1gain in the market, it is the riskiest stock and should command the highest premium, followed by (racker with "ober being the least risk option of the three. Moving on to 203M "o if the risk premium commanded by the stock market is #/, then the risk premium that investors should demand for a particular stock is beta times #/. 203M states that the e#pected return on a stock is the sum of a 4risk%free rate' and 4stock beta times market risk premium'. (his, in essence, is the capital asset pricing model (203M . 0fter all, why should anyone e#pect to earn more by investing in one stock as opposed to another& 5ou need to be compensated for doing badly when times are bad. (he stock that is wont to do badly 6ust when you need money in trying times is a stock you should hate, and there had better be some redeeming virtue or else who would want to hold it& !ow is beta calculated& +h, we are not going to give you some longwinded formula. 0fter all these days, you do not need to know how a computer works to actually use one. "o, we shall never trouble you with formulae, but 6ust e#plain the concept. 0n analyst calculating the beta of a stock obtains the historical returns of that stock over a period and then compares them using 'linear regression' to the returns on the inde#. It is 6ust enough for most of

us to know that linear regression is a statistical tool for estimating beta. "ome pertinent 7uestions to ask at this stage 89 Is the beta of a stock constant? A: (he beta of a stock can change over time as the stock's characteristics transform. .or e#ample, a stock moving from the :) group to the 0 group sometime back would have changed the beta of the stock. 0fter all, the underlying li7uidity of the stock would have changed as 0 group stocks have this carry forward mechanism that attracts a whole host of speculators. 89 Can a low beta stock be more volatile than a high beta stock? A: Interestingly, a low beta stock could be more volatile than a high beta stock. ;emember, the beta measures only the systemic risk or the influence of the market on the stock whereas a stock on its own might have a very high unsystemic risk because of the risk associated with the company's business. $rapping up today's spoils (he key insight of the capital asset pricing model is that higher e#pected returns go with the greater risk of doing badly in bad times. :eta is a measure of a stock's tendency to move with the market. "tocks with high betas tend to do worse in market downturns than those with low betas. Our advice: If your heart has a high beta level, invest in a stock that has a low beta! Copyright 2002 harekhan!co" # <1:+=5.< span html<> Copyright 200) harekhan!co" # $I Investor ervices %vt! &td! 'll (ights (eserved $I Investor ervices %vt! &td! 'll (ights (eserved!