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BETA
The beta is used to measure the
underversifiable risk of an asset. That is, it is used to measure the systematic
risk of an asset. We all know we have two systematic and unsystematic risk.
The formula for Beta:
β= R2
– R1
M2
– M1
Where:
R2
= Return on individual security
M2
= Return on the portfolio
ILLUSTRATION:
Consider the following data
which gives a security analyst expected return on two stocks for two particular
market returns.
|
Market
Return
|
Aggressive
Stock
|
Defensive
Stock
|
|
5%
|
-2%
|
6%
|
|
25%
|
38%
|
12%
|
- What are the Betas of the two stocks?
- What is the expected Return on each stock if the market return is equally likely to be 5% or 25%?
- If the risk free Rate of Return is 6% and the market return is equally likely to be 5% or 25%, what is the SML?
- What are the Alphas of the two stocks ?
- Which stock is undervalued and which stock is overvalued?
SOLUTION:
First
of all, we have to determine the beta of the Aggressive Stock before the
Defensive stock.
Here
we go:
β= R2
– R1
M2
– M1
β= 38-(
–2)
25-5
Explanation: Do you know how we got 38? 38 is R2, which is
the aggressive stock figure row2, while -2 is the aggressive stock figure in
row1.
Then 25%
is the market rate of return in row2 while 5 is the market rate of return in row
1. Please look at the formula again.
So
let continue:
β= 40
20
Don’t ask
me how I got the 40 above, because minus multiply by minus gives you plus.
β= 2
Our beta
for Aggressive stock is 2.
Now with
that we can solve for Defensive. It is
the same procedure:
Defensive
Stock:
β= R2
– R1
M2
– M1
β= 12-6
25-5
β= 6
20
β= 0.3
Our
Defensive stock is 0.3
I will
bring us the remaining part of this question in less than 2 hours of this
post. That is to say solution to b-e.
Tnks for all the info, remain blessed.
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