Beta risk
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Beta risk, also known as non-diversifiable risk, is the risk of an investment that is associated with the market as a whole. Beta risk is the risk that cannot be eliminated by diversifying a portfolio. Beta risk is measured by the volatility of returns. A higher beta indicates more risk, while a lower beta indicates less risk. The formula for Beta risk is:
Beta risk is an important part of financial analysis because it is a measure of how much an individual asset is exposed to market risk. By understanding the Beta of an asset, investors can make better informed decisions about how much risk they are willing to take on.
Example of Beta risk
Beta risk can be seen in the stock market. For example, if a company has a beta of 2, this means that it is twice as volatile as the market as a whole. This means that when the market rises, the company's stock will rise more than the market, and when the market falls, the company's stock will fall more than the market.
In conclusion, Beta risk is an important measure of risk associated with an investment. It measures the volatility of returns relative to the market as a whole and is an important part of financial analysis. By understanding Beta risk, investors can make better informed decisions about how much risk they are willing to take on.
Formula of Beta risk
Beta risk is calculated using the formula
where /beta;a,m is the Beta of asset a, /sigma;a,m is the volatility of the asset relative to the market, and $\sigma_m$ is the volatility of the market. This formula allows investors to measure the amount of risk associated with an asset and compare it to the overall market risk.
The Beta of an asset is a measure of the asset’s volatility relative to the market. A Beta greater than 1 indicates the asset is more volatile than the market, while a Beta less than 1 indicates the asset is less volatile than the market. A Beta of 1 indicates the asset has the same volatility as the market.
By understanding the Beta of an asset, investors can make better informed decisions about how much risk they are willing to take on. They can also assess the potential return of an investment and compare it to the amount of risk associated with the investment.
When to use Beta risk
- Beta risk is most commonly used to measure the risk associated with stocks and other assets. By looking at the Beta of a stock, an investor can determine how much the stock is likely to move in relation to the overall market.
- Beta risk is also used to compare the relative risk of different stocks or assets within a portfolio. By comparing the Betas of different assets, investors can determine which assets are more or less risky, and adjust their portfolio accordingly.
- Beta risk can also be used to assess the risk of an entire portfolio. By looking at the Beta of the entire portfolio, investors can get a better sense of the overall risk of their investments.
Types of Beta risk
- Systematic risk: Systematic risk is the risk that affects all assets in the market. It is the risk associated with macroeconomic events such as recessions, wars, or natural disasters that affect the entire market.
- Unsystematic risk: Unsystematic risk is the risk that only affects certain assets. This can include things such as company specific events such as a new product launch or a change in the company’s management.
- Idiosyncratic risk: Idiosyncratic risk is the risk that is specific to an individual asset. This can include things such as changes in the political landscape or new regulations that affect only a certain asset.
Steps of Beta risk
- Calculate Returns: The first step to calculating Beta risk is to calculate the rate of return for the asset and the market. This can be done by finding the percentage change in the price of the asset over a given period.
- Calculate Volatility: The next step is to calculate the volatility of the asset's returns relative to the market's returns. This can be done by calculating the standard deviation of the asset's returns and the market's returns.
- Calculate Beta: The final step is to calculate the Beta of the asset by dividing the volatility of the asset's returns by the volatility of the market's returns.
Advantages of Beta risk
- Beta risk is an important part of financial analysis because it is a measure of how much an individual asset is exposed to market risk. By understanding the Beta of an asset, investors can make better informed decisions about how much risk they are willing to take on.
- Beta risk can be used to measure the sensitivity of an asset to market movements. This can help investors identify assets that are more or less volatile than the overall market.
- Beta risk can be used to compare the riskiness of different assets. By understanding the Beta of an asset, investors can decide which assets to include in their portfolio.
Limitations of Beta risk
Beta risk has several limitations that should be taken into consideration when using it for analysis. These limitations include:
- Beta does not account for other types of risk such as liquidity risk, credit risk, and political risk.
- Beta does not always accurately reflect the true level of risk of an individual asset, as it is based on past performance.
- Beta does not account for the impact of unsystematic risk, which is risk that is specific to an individual asset or sector.
- Systematic risk: Systematic risk is the risk associated with the entire market. It is the risk of loss due to macroeconomic factors like inflation, recession, or a change in government policy. Systematic risk cannot be diversified away, and it is not specific to any one asset.
- Unsystematic risk: Unsystematic risk is the risk associated with individual assets or sectors. It is the risk of loss due to factors that are specific to a company or industry, such as management, competition, or product quality. Unsystematic risk can be diversified away by investing in multiple assets.
- Idiosyncratic risk: Idiosyncratic risk is the risk associated with an individual asset or company. It is the risk of loss due to factors that are specific to the company, such as management, competition, or product quality. Idiosyncratic risk can be diversified away by investing in multiple assets.
In summary, Beta risk is the risk of an investment that is associated with the market as a whole, and is measured by the volatility of returns. Systematic, unsystematic, and idiosyncratic risk are all related to Beta risk, but are different in terms of their sources and the degree to which they can be diversified away.
Suggested literature
- Chan, L. K., & Lakonishok, J. (1992). Robust measurement of beta risk. Journal of financial and quantitative analysis, 27(2), 265-282.
- Faff, R. W., Hillier, D., & Hillier, J. (2000). Time varying beta risk: An analysis of alternative modelling techniques. Journal of Business Finance & Accounting, 27(5‐6), 523-554.
- Lie, F., Brooks, R., & Faff, R. (2000). Modelling the equity beta risk of Australian financial sector companies. Australian economic papers, 39(3), 301-311.
