Beta is a numeric value that measures the fluctuations of a stock to changes in the overall stock market.

Beta measures the responsiveness of a stock’s price to changes in the overall stock market. On comparison of the benchmark index for e.g. NSE Nifty to a particular stock returns, a pattern develops that shows the stock’s openness to the market risk. This helps the investor to decide whether he wants to go for the riskier stock that is highly correlated with the market (beta above 1), or with a less volatile one (beta below 1).

Beta Value Equal to 1.0

If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with the market. A stock with a beta of 1.0 has systematic risk. However, the beta calculation can’t detect any unsystematic risk. Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the portfolio will provide an excess return.

Beta Value Less Than One

A beta value that is less than 1.0 means that the security is theoretically less volatile than the market. Including this stock in a portfolio makes it less risky than the same portfolio without the stock. For example, utility stocks often have low betas because they tend to move more slowly than market averages.

Beta Value Greater Than One

A beta that is greater than 1.0 indicates that the security’s price is theoretically more volatile than the market. For example, if a stock’s beta is 1.2, it is assumed to be 20% more volatile than the market. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but may also increase its expected return.

Negative Beta Value

Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark on a 1:1 basis. This stock could be thought of as an opposite, mirror image of the benchmark’s trends. Put options and inverse ETFs are designed to have negative betas.

How the expected change in the value of a stock can be determined by using beta?

By multiplying the beta value of a stock with the expected movement of an index, the expected change in the value of the stock can be determined. For example, if beta is 1.2 and the market is expected to move up by 10%, then the stock should move up by 12% (1.2 x 10).

Beta is the key factor used in the Capital Asset Price Model (CAPM) which is a model that measures the return of a stock. The volatility of the stock and systematic risk can be judged by calculating beta. A positive beta value indicates that stocks generally move in the same direction with that of the market and the vice versa.

PRACTICE QUESTIONS

QUES . In the context of finance, the term ‘beta’ refers to: UPSC 2023

(a) the process of simultaneous buying and selling of an asset from difference platforms.

(b) an investment strategy of a portfolio manager to balance risk versus reward.

(c) a type of systemic risk that arises where perfect hedging is not possible.

(d) a numeric value that measures the fluctuations of a stock to changes in the overall stock market

Ans (d)