In finance, the beta (β) of a stock or portfolio is a number describing the relation of its

returns with that of the financial market as a whole.[1]

An asset with a beta of 0 means that its price is not at all correlated with the market. A
positive beta means that the asset generally follows the market. A negative beta shows
that the asset inversely follows the market; the asset generally decreases in value if the
market goes up and vice versa.[2]

The beta coefficient is a key parameter in the capital asset pricing model (CAPM). It
measures the part of the asset's statistical variance that cannot be mitigated by the
diversification provided by the portfolio of many risky assets, because it is correlated
with the return of the other assets that are in the portfolio. Beta can be estimated for
individual companies using regression analysis against a stock market index.

Contents
Definition
If beta = 1, it is neither more nor less volatile than the market index as a whole. The
formula for the beta of an asset within a portfolio is

where ra measures the rate of return of the asset, rp measures the rate of return of the
portfolio, and cov(ra,rp) is the covariance between the rates of return. The portfolio of
interest in the CAPM formulation is the market portfolio that contains all risky assets,
and so the rp terms in the formula are replaced by rm, the rate of return of the market.

Beta is also referred to as financial elasticity or correlated relative volatility, and can be
referred to as a measure of the sensitivity of the asset's returns to market returns, its non-
diversifiable risk, its systematic risk, or market risk. On an individual asset level,
measuring beta can give clues to volatility and liquidity in the marketplace. In fund
management, measuring beta is thought to separate a manager's skill from his or her
willingness to take risk.

The beta coefficient was born out of linear regression analysis. It is linked to a regression
analysis of the returns of a portfolio (such as a stock index) (x-axis) in a specific period
versus the returns of an individual asset (y-axis) in a specific year. The regression line is
then called the Security characteristic Line (SCL).
αa is called the asset's alpha and βa is called the asset's beta coefficient. Both
coefficients have an important role in Modern portfolio theory.

For an example, in a year where the broad market or benchmark index returns 25% above
the risk free rate, suppose two managers gain 50% above the risk free rate. Since this
higher return is theoretically possible merely by taking a leveraged position in the broad
market to double the beta so it is exactly 2.0, we would expect a skilled portfolio manager
to have built the outperforming portfolio with a beta somewhat less than 2, such that the
excess return not explained by the beta is positive. If one of the managers' portfolios has
an average beta of 3.0, and the other's has a beta of only 1.5, then the CAPM simply
states that the extra return of the first manager is not sufficient to compensate us for that
manager's risk, whereas the second manager has done more than expected given the risk.
Whether investors can expect the second manager to duplicate that performance in future
periods is of course a different question.

Security market line

Main article: Security market line

The SML graphs the results from the capital asset

pricing model (CAPM) formula. The x-axis
represents the risk (beta), and the y-axis represents the
expected return. The market risk premium is
determined from the slope of the SML.
The Security Market Line
The relationship between β and required return is plotted on the security market line
(SML) which shows expected return as a function of β. The intercept is the nominal risk-
free rate available for the market, while the slope is E(Rm)− Rf. The security market line
can be regarded as representing a single-factor model of the asset price, where Beta is
exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a

reasonable expected return for risk. Individual securities are plotted on the SML graph. If
the security's risk versus expected return is plotted above the SML, it is undervalued
since the investor can expect a greater return for the inherent risk. And a security plotted
below the SML is overvalued since the investor would be accepting less return for the
amount of risk assumed.

[edit] Beta volatility and correlation

There is a simple formula between beta and volatility (sigma):
That is, beta is a combination of volatility and correlation. For example, if one stock has
low volatility and high correlation, and the other stock has low correlation and high
volatility, beta can decide which is more "risky".

This also leads to an inequality (since |r| is not greater than one):

In other words, beta sets a floor on volatility. For example, if market volatility is 10%,
any stock (or fund) with a beta of 1 must have volatility of at least 10%.

Another way of distinguishing between beta and correlation is to think about direction
and magnitude. If the market is always up 10% and a stock is always up 20%, the
correlation is one (correlation measures direction, not magnitude). However, beta takes
into account both direction and magnitude, so in the same example the beta would be 2
(the stock is up twice as much as the m

Published betas typically use a stock market index such as S&P 500 as a benchmark. The
benchmark should be chosen to be similar to the other assets chosen by the investor.
Other choices may be an international index such as the MSCI EAFE. The choice of the
index need not reflect the portfolio under question; e.g., beta for gold bars compared to
the S&P 500 may be low or negative carrying the information that gold does not track
stocks and may provide a mechanism for reducing risk. The restriction to stocks as a
benchmark is somewhat arbitrary. Sometimes the market is defined as "all investable
assets" (see Roll's critique); unfortunately, this includes lots of things for which returns
may be hard to measure.

[edit] Investing
By definition, the market itself has an underlying beta of 1.0, and individual stocks are
ranked according to how much they deviate from the macro market (for simplicity
purposes, the S&P 500 is usually used as a proxy for the market as a whole). A stock
whose price moves more than the market over time has a beta whose absolute value is
greater than 1.0. A stock price that moves less than the market has an absolute value of
less than 1.0.

A stock with a beta of 2 moves by twice the magnitude of the overall market; when the
market falls or rises by 3%, the stock will fall or rise by 6%. Betas can also be negative,
meaning the stock moves in the opposite direction of the market.A stock with a beta of -3
would decline 9% when the market goes up 3%, and would climb 9% if the market falls
by 3%.

Higher-beta stocks are more volatile and therefore riskier but provide the potential for
higher returns. Lower-beta stocks pose less risk but offer lower returns. Some have
challenged this idea, claiming that the data show little relation between beta and potential
reward, or even that lower-beta stocks are both less risky and more profitable
(contradicting CAPM). In the same way a stock's beta shows its relation to market shifts,
it is also an indicator for required returns on investment (ROI). If the market with a beta
of 1 has an expected return of 8%, a stock with a beta of 1.5 should return 12%.

[edit] Academic theory

Academic theory claims that higher-risk investments should have higher return long-
term. Wall Street saying is that "higher return requires higher risk", not that a risky
investment will automatically do better. Some things may just be poor investments (e.g.,
playing roulette or lighting money on fire). Further, highly rational investors should use
correlated volatility (beta) instead of simple volatility (sigma).

This expected return on equity, or equivalently, a firm's cost of equity, can be estimated
using the Capital Asset Pricing Model (CAPM). According to the model, the expected
return on equity is a function of a firm's equity beta (βE) which, in turn, is a function of
both leverage and asset risk (βA):

where:

• KE = firm's cost of equity

• RF = risk-free rate (the rate of return on a "risk free investment", e.g. U.S.
Treasury Bonds)
• RM = return on the market portfolio

because:

and

Firm Value (V) = Debt Value (D) + Equity Value (E)

An indication of the systematic riskiness attaching to the returns on ordinary shares. It

equates to the asset Beta for an ungeared firm, or is adjusted upwards to reflect the extra
riskiness of shares in a geared firm., i.e. the Geared Beta.[3]

[edit] Multiple beta model

The arbitrage pricing theory (APT) has multiple betas in its model. In contrast to the
CAPM that has only one risk factor, namely the overall market, APT has multiple risk
factors. Each risk factor has a corresponding beta indicating the responsiveness of the
asset being priced to that risk factor.

Mutiple-factor models contradict CAPM by claiming that some other factors can return,
therefore one may find two stocks (or funds) with equal beta, but one may be a better
investment.

[edit] Estimation of beta

To estimate beta, one needs a list of returns for the asset and returns for the index; these
returns can be daily, weekly or any period. Then one uses standard formulas from linear
regression. The slope of the fitted line from the linear least-squares calculation is the
estimated Beta. The y-intercept is the alpha.

Myron Scholes and Joseph Williams (1977) provided a model for estimating betas from
nonsynchronous data.[4]

Beta is commonly misexplained as asset volatility relative to market volatility. If that

were the case it should simply be the ratio of these volatilities. In fact, the standard
estimation uses the slope of the least squares regression line—this gives a slope which is
less than the volatility ratio. Specifically it gives the volatility ratio multiplied by the
correlation of the plotted data. To take an extreme example, something may have a beta
of zero even though it is highly volatile, provided it is uncorrelated with the market.
Tofallis (2008) provides a discussion of this,[5] together with a real example involving
AT&T. The graph showing monthly returns from AT&T is visibly more volatile than the
index and yet the standard estimate of beta for this is less than one.

The relative volatility ratio described above is actually known as Total Beta (at least by
appraisers who practice business valuation). Total Beta is equal to the identity: Beta/R or
the standard deviation of the stock/standard deviation of the market (note: the relative
volatility). Total Beta captures the security's risk as a stand-alone asset (since the
correlation coefficient, R, has been removed from Beta), rather than part of a well-
diversified portfolio. Since appraisers frequently value closely-held companies as stand-
alone assets, Total Beta is gaining acceptance in the business valuation industry.
Appraisers can now use Total Beta in the following equation: Total Cost of Equity
(TCOE) = risk-free rate + Total Beta*Equity Risk Premium. Once appraisers have a
number of TCOE benchmarks, they can compare/contrast the risk factors present in these
publicly-traded benchmarks and the risks in their closely-held company to better
defend/support their valuations.

[edit] Extreme and interesting cases

 • Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with
highly volatile stocks.
• Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds and
cash. However, simply because a beta is zero does not mean that it is risk-free. A
beta can be zero simply because the correlation between that item and the market
is zero. An example would be betting on horse racing. The correlation with the
market will be zero, but it is certainly not a risk-free endeavor.
• A negative beta simply means that the stock is inversely correlated with the
market. Many precious metals and precious-metal-related stocks are beta-negative
as their value tends to increase when the general market is down and vice versa.[2]
• A negative beta might occur even when both the benchmark index and the stock
under consideration have positive returns. It is possible that lower positive returns
of the index coincide with higher positive returns of the stock, or vice versa. The
slope of the regression line, i.e. the beta, in such a case will be negative.
• If it were possible to invest in an asset with positive returns and beta −1 as well as
in the market portfolio (which by definition has beta 1), it would be possible to
achieve a risk-free profit. With the use of leverage, this profit would be unlimited.
Of course, in practice it is impossible to find an asset with beta −1 that does not
introduce additional costs or risks.
• Using beta as a measure of relative risk has its own limitations. Most analysis
consider only the magnitude of beta. Beta is a statistical variable and should be
considered with its statistical significance (R square value of the regression line).
Higher R square value implies higher correlation and a stronger relationship
between returns of the asset and benchmark index.
• If beta is a result of regression of one stock against the market where it is quoted,
betas from different countries are not comparable.
• Staple stocks are thought to be less affected by cycles and usually have lower
beta. Procter & Gamble, which makes soap, is a classic example. Other similar
ones are Philip Morris (tobacco) and Johnson & Johnson (Health & Consumer
Goods). Utility stocks are thought to be less cyclical and have lower beta as well,
for similar reasons.
• 'Tech' stocks typically have higher beta. An example is the dot-com bubble.
Although tech did very well in the late 1990s, it also fell sharply in the early
2000s, much worse than the decline of the overall market.
• Foreign stocks may provide some diversification. World benchmarks such as S&P
Global 100 have slightly lower betas than comparable US-only benchmarks such
as S&P 100. However, this effect is not as good as it used to be; the various
markets are now fairly correlated, especially the US and Western Europe.[citation
needed]

[edit] Criticism
Beta is not without its own criticisms. Seth Klarman of the Baupost group wrote in his
timely classic Margin of Safety: "I find it preposterous that a single number reflecting
past price fluctuations could be thought to completely describe the risk in a security. Beta
views risk solely from the perspective of market prices, failing to take into consideration
specific business fundamentals or economic developments. The price level is also
ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment
than the same IBM at 100 dollars per share. Beta fails to allow for the influence that
investors themselves can exert on the riskiness of their holdings through such efforts as
proxy contests, shareholder resolutions, communications with management, or the
ultimate purchase of sufficient stock to gain corporate control and with it direct access to
underlying value. Beta also assumes that the upside potential and downside risk of any
investment are essentially equal, being simply a function of that investment's volatility
compared with that of the market as a whole. This too is inconsistent with the world as
we know it. The reality is that past security price volatility does not reliably predict future
investment performance (or even future volatility) and therefore is a poor measure of
risk."[6] Beta is also used to analyze the underlying implication of capital structuAlpha
(finance)

[edit] External links

• ETFs & Diversification: A Study of Correlations on indexuniverse.com
• The Beta Brief Commentary/analysis on matters related to beta including ETFs.
• Paper describing the effect of leverage and default risk on beta

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