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Chapter 17


The minimax decision strategy is to choose the decision alternative that will
minimize the maximum opportunity loss or regret. In this problem, the maximum
possible regret is associated with the upgrade decision. This maximum possible
regret can be avoided by choosing the no upgrade decision, the minimax strategy.


Stock-Price Beta Estimation for the Royal Dutch Petroleum Company
Statisticians use the Greek letter beta to signify the slope coefficient in a linear relation.
Financial economists use this same Greek letter to signify stock-price risk because betas are
the slope coefficients in a simple linear relation that links the return on an individual stock to the
return on the overall market in the capital asset pricing model (CAPM). In the CAPM, the
security characteristic line shows the simple linear relation between the return on individual
securities and the overall market at every point in time :
R it = i + i R Mt + i , where Rit is the rate of return on an individual security i during period t,
the intercept term is described by the Greek letter (alpha), the slope
coefficient is the Greek letter (beta) and signifies systematic risk (as before), and the random
disturbance or error term is depicted by the Greek letter (epsilon). At any point in time, the
random disturbance term has an expected value of zero. This means that the expected return
on an individual stock is determined by and .
The slope coefficient shows the anticipated effect on an individual security=s rate of
return following a 1% change in the market index. If = 1.5, then a 1% rise in the market
would lead to a 1.5% hike in the stock price, a 2% boost in the market would lead to a 3% jump
in the stock price, and so on. If = 0, then the rate of return on an individual stock is totally
unrelated to the overall market. The intercept term shows the anticipated rate of return when
either = 0 or RM = 0. When > 0, investors enjoy positive abnormal returns. When < 0,
investors suffer negative abnormal returns. Investors would celebrate a mutual fund manager
whose portfolio consistently generated positive abnormal returns ( > 0). They would fire
portfolio managers that consistently suffered negative abnormal returns ( < 0). In a perfectly
efficient capital market, the CAPM asserts that investor rates of return would be solely
determined by systematic risk and both alpha and epsilon would equal zero, = = 0.
Figure 17.8 here
As shown in Figure 17.8, managers and investors can estimate beta for individual stocks
by using a simple ordinary least-squares regression model. In this simple regression model, the
dependent Y-variable is the rate of return on an individual stock, and the independent X-variable
is the rate of return on an appropriate market index. Within this context, changes in the stock
market rate of return are said to cause changes in the rate of return on an individual stock. In
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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Risk Analysis
this example, beta is estimated for the Royal Dutch Petroleum Company (ticker symbol: RD), the
holding company for the Royal Dutch/Shell Group of Companies. Present in more than 145
countries and territories worldwide, the Royal Dutch/Shell Group of Companies are engaged in
the business of exploration and production of natural gas, electric power, oil products,
chemicals and related products. The price data used to estimate beta for RD were downloaded
for free from the Internet at the Yahoo! Finance Web site (
Monthly returns for RD and for the Standard & Poor=s 500 were analyzed over a five-year
period (60 observations), as shown in Table 17.7.
In this case, as predicted by the CAPM, = 0.0021 .0. During a typical month when the
overall market return is zero (essentially flat), the return for RD common stockholders is
expected to be zero as well. The slope coefficient = 0.6892 is statistically significant (t = 5.47).
There is a meaningful empirical relationship between movement in the overall market and RD
stock, at least on a statistical basis. Because < 1, RD is less volatile than the overall market.
During a month when the overall market rises by 1%, RD can be expected to rise by 0.69%;
during a month when the market falls by 1%, RD can be expected to fall by 0.69%.
Table 17.7 here
The usefulness of betas as risk measures can be undermined by the fact that the simple
linear model used to estimate stock-price beta fails to include other important systematic
influences on stock market volatility. In the case of RD, for example, R2 information shown in
Figure 17.8 indicates that only 34.03% of the total variation in RD returns can be explained by
variation in the overall market. This means that 65.97% of the variation in weekly returns for
RD stock is unexplained by such a simple regression model. Although the amount of explained
variation is statistically significant, it may not be economically meaningful in the sense of
providing investors with consistently useful risk information.


Describe some of the attributes of an ideal risk indicator for stock market investors.

On the Internet, go to Yahoo! Finance (or msnMoney) and download weekly price
information over the past year (52 observations) for RD and the S&P 500. Then, enter this
information in a spreadsheet like Table 17.7 and use these data to estimate RD=s beta. Describe
any similarities or dissimilarities between your estimation results and the results depicted in
Figure 17.8.
Estimates of stock-price beta are known to vary according to the time frame analyzed;
length of the daily, weekly, monthly, or annual return period; choice of market index; bull or
bear market environment; and other nonmarket risk factors. Explain how such influence can
undermine the usefulness of beta as a risk indicator. Suggest practical solutions.


Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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Chapter 17

An ideal measure of stock market risk would be simple to derive, accurate and
consistent from one year to another. With an ideal risk measure, investors are able to control the
risk exposure faced during volatile markets with well-targeted and well-timed investment
buy/sell decisions. For example, suppose an elderly investor wants to maintain an exposure to
the equity markets during retirement, but wants to limit risk to regulate the possibility of
devastating losses. With an ideal risk measure, retired investors could precisely tilt portfolio
allocation toward securities with low risk characteristics. Alternatively, if an investor
anticipated a surge in stock prices following a decline in interest rates, precise risk measures
could help such an investor tilt an investment portfolio toward more volatile stocks.
The usefulness of stock market risk indicators diminishes to the extent that they
fail to provide accurate and consistent measures of risk exposure from one year to
another. In fact, an important limitation of risk estimators derived from the CAPM is
that they vary from one period to another in ways that prove highly unpredictable.
When betas vary from one year to another in ways that are essentially random and
unpredictable, betas fail to provide investors with a risk assessment tool that can be
used to effectively manage portfolio risk.
It will be a real eye-opener to students when they estimate stock-price beta for RD
over a more recent time period using weekly returns and compare those results with the beta
estimate derived from the monthly returns reported in Table 17.7 for the June, 1999 to June,
2004 time period, as shown in Figure 17.8. Stock-price beta estimates often vary markedly
depending upon the time frame analyzed, and according to the daily, weekly, monthly, or annual
return interval examined. Such differences, if severe, can undermine the credibility of stockprice betas as useful risk indicators.
Empirical estimates of stock-price beta are known to vary according to the time
frame analyzed; length of the daily, weekly, monthly, or annual return period; choice of market
index; bull or bear market environment; and other nonmarket risk factors. For example,
estimates of beta tend to be imperfect risk measures because return volatility for the overall
market is very difficult to measure. On the nightly news, when commentators talk about the
market being up or down, they often refer to moves in the DJIA. Whereas the DJIA offers good
insight concerning changes in the prices of large blue chip companies, it offers little insight
concerning volatility in the returns earned by investors in smaller high-tech stocks. From the
perspective of many individual and institutional investors, the S&P 500 Index gives superior
insight concerning moves in the overall market, but like the DJIA, the S&P 500 is dominated by
large blue chip companies. Although the Nasdaq and Russell 2000 indexes are popular
measures of high-tech and smaller stocks, they are much less informative about changes in the
overall market. While there is a high degree of correlation in rates of return earned on the DJIA,
S&P 500, Nasdaq, and Russell 2000 indexes, slight differences can have big effects on beta
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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Risk Analysis

From a theoretical perspective, the most appropriate benchmark would be a

market index that included all capital assets, including stocks, bonds, real estate,
collectibles, and so on. Unfortunately, no such market index is available. To greater
or lesser degree, this affects the accuracy of all beta estimates and undermines
confidence in beta as an accurate measure of security risk. Another important
problem faced in obtaining consistent and reliable beta estimates is the fact that beta
estimates are sensitive to the length of time over which stock return data are
measured. When beta estimates differ according to daily, weekly, monthly or annual
returns, the usefulness of stock-price beta as a consistent measure of risk is greatly
The presence of market index bias and return interval bias, among other
problems, makes it imperative that beta comparisons among individual companies
reflect identical estimation periods, return intervals, and appropriate market

Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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