Management & Financial Accounts

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CA Prabhakar Dubey (Querist)
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22 November 2007
Please any one can help me how to calculate beta (B) which helps to calculate cost of equity and overall cost of capital.

S.Srinivasaraghavan

S.Srinivasaraghavan (Expert)
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22 November 2007 The Beta coefficient, in terms of finance and investing, is a measure of a stock (or portfolio)’s volatility in relation to the rest of the market. Beta is calculated for individual companies using regression analysis.

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.

For example, if every stock in a Stock Exchange was uncorrelated with every other stock, then every stock would have a Beta of zero, and it would be possible to create a portfolio that was nearly risk free, simply by diversifying it sufficiently so that the variations in the individual stocks' prices averaged out. This would be like owning a casino: essentially none of the business risk of owning a casino comes from the uncertain outcomes of the games of chance played by the customers, because those are uncorrelated, and average out over any significant period of time. In reality, investments tend to be correlated, more so within an industry, or when considering a single asset class (such as equities), as was demonstrated in the Wall Street crash of 1929. This correlated risk, measured by Beta, is what actually creates almost all of the risk in a diversified portfolio.

The formula for the Beta of an asset within a portfolio is,

Beta(a)= Cov[r(a), r(p)]/Var.r(p)

where r(a) measures the rate of return of the asset, r(p) measures the rate of return of the portfolio of which the asset is a part and Cov(ra,rp) is the covariance between the rates of return. In the CAPM formulation, the portfolio 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.

Source: Wikipedia

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