Hello Everyone,
As per the definition, equity beta captures the systematic risk. However, further, it has also been stated that it captures the business risk and leverage risk which are the type of unsystematic risk.
Can anyone please, elaborate this further? Like how and why.
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While I don't give a shit about beta and think it's an academia bs concept trying to be a smart-a, but my understanding is
Unlevered Beta = Inherent business risk >>> Capital structure neutral
Levered Beta = Unlevered Beta + risk coming from capital structure
Levered (equity) beta = Unlevered (asset) beta* (1+ (1- Tax)*D/E).
Unlevered (asset) beta assesses the business risk regardless of capital structure and Bu*RPM is the compensation for that business risk.
Levered (equity) beta reflects total risk and takes into account capital structure through the D/E ratio and the tax rate. (Beta lev - Beta unl)*RPM is the compensation for financial/leverage risk.
CAPM, and more specifically beta, is a measure of systematic (market risk), that is, risk that cannot be diversified away. This mainly refers to volatility with respect to the market.
Unsystematic (idiosyncratic) risk is risk that cannot be diversified away. For example, think of the Enron scandal.
All in all, beta is ass and it only helps you look at systematic risk if you believe that volatility and capital structure are what constitutes systematic risk. This is more of an academia concept with less real-life applications. I don't know a single analyst that puts any thought into beta after pulling it from factset.
Edit: Unsystematic risk can be diversified away
Thanks for your detailed answer.
1. So basically, we can say that beta captures both systematic risk and unsystematic risk (incl. leverage) if we believe that it can be defined by the market correlation.
2. As per CAPM, we assume that the unsystematic risk can be diversified away so beta in context with CAPM only captures systematic risk as we ignore the other risk based on the assumption.
Did I get it right?
Almost, beta doesn’t explain unsystematic risk.
CAPM = model that explains systematic risk
Beta is part of CAPM, and CAPM plots beta against the expected return of the security/portfolio.
1- Systematic Risk
1A-CAPM
Levered (equity) beta is the volatility of a security based on how it behaves with respect to the market, while the asset beta refers to the business risk relative to the market and neutral to the capital structure.
We compare how the equity moves with respect to the market because it’s the best way to measure risk that we cannot mitigate(systematic). For example, we cannot control a market downturn or how interest rates will behave, but we can look at how a given security behaves under this conditions relative to the market (systematic risk refers to actions that affect the entire market not just a given firm). Think about it this way, a stock with an equity beta of 2 will move 2 as much as the market. If the market goes up 10%, the equity will go up 20%. However, this also makes it riskier than the market, since a 10% drop in the market will represent a 20% drop in the stock.
Beta (a,m) = COV (a,m) / variance market
When I talk about beta, I’m mainly referring to equity beta since it’s rare to see a company with no debt on their capital structure. The main take away is that beta is part of CAPM and CAPM is a model that explains systematic risk.
Unsystematic risk on the other hand can be diversified away because they are asset/business specific. A drop in price of a commodity can be mitigated by investing in other commodities. Change in demand for coal can be mitigated by investing in different industries. A well-diversified portfolio will bring unsystematic risk near 0.
Total Risk = Systematic + Unsystematic
The goal is to make total risk = systematic, or at least get as close as possible.
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