beta and systematic risk
in finance, beta can be either interpreted as the asset's sensitivity towards the market, in terms of return, or as the systematic risk.
i understand the first interpretation, but i just cant get the second one, as:
- how can beta be the systematic risk if the beta can be negative? i cant see how the systemati risk can be negative
- beta varies between companies, but the systematic risk, also called market risk,is supposed to be the same for all companies.
im not american so sorry for my english
thank you
I am by no means putting forth and end all be all answer; just hoping to help. Hopefully someone will explain it better.
1) Beta can be negative because it tries to quantify the relationship between the stock (or whatever else you are applying it to) and the market. Gold is an example of something with a negative beta. Remember, this doesn't represent zero-risk. It shows that, all else equal, the gold should move opposite the market as a whole in a macro setting. Try to think about it more like a relationship.
2) I don't really understand your question but I will try to answer it. The beta varies between different companies because at the end of the day each company is different. No two are alike. They are compared to the market as a whole (in the form of returns, etc.) in order to attempt to quantify the risk. The risk that matters is the systematic risk. People try to mitigate or diversify away the company specific risk in a set of portfolios. You aren't looking at the risk of the market each time you look at beta; you are looking at how the stock (or whatever you are applying statistics to) interacts with the market. There is a return for risk taking; however, the market doesn't reward unnecessary risk taking. Unnecessary risk taking=not diversifying away the company specific risk.
in the first question, it's not that i dont understand how beta can be negative, this i do understand. im questioning the fact that, given the beta can be negative, how can it be interpreted as systematic risk?
in the second one its not that i dont understand how the beta varies. what i dont understand is that the beta varies, but the systematic risk does not. so how can they be the same thing?
Beta is the measurement tool. Just because the Beta is negative doesn't mean the risk (systematic) doesn't still exist.
Beta shows how the company should react to systematic risk. This is why beta will vary from company to company while systematic risk will stay constant.
did that answer your question?
The CAPM assumes the market is observable (a portfolio of all available assets) and it assumes that there's only one source of risk and that is market risk. This means that the risk a company faces is the market. Company specific risk is assumed to be diversified away. So the reason why beta's are different amongst companies is because each company/stock/portfolio reacts differently to market changes / market risk. Company specific risk that is diversified away would be how a specific company reacts to oil price changes, seasonal factors etc. the only risk that remains is market risk. But still each company can react differently to market changes. Thus market risk isn't the same for all companies. A negative beta would mean a stock has a negative sensitivity to market movements, is possible not witnessed very often, beta's based on historical info aren't that useful anyways, but that's a whole other discussion.
@DaveWinkler
actually yes, but the only thing is i have never found such explanation in any textbook
thx
Hi, sorry to bring up this question again. I have the same question as Kinglee. I have 2 equities (i.e. same dollar amount). Equity A is with -2 beta while Equity B is with +2 beta. Am I have market risk? Thanks a lot!
If your portfolio is equally invested in both equities then your portfolio will move like the market. Some zero-beta assets are risk-free, such as treasury bonds and cash. However, simply because a beta is zero does not mean that it is risk-free. A beta can be zero simply because the correlation between that item's returns and the market's returns is zero. An example would be betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk-free endeavor.
Beta is really just covariance, normalized by market variance. If you don't understand where Beta comes from (linear regression), you shouldn't be using it in analysis.
Beta's inability to isolate systemic risk (Originally Posted: 08/03/2015)
Hi,
I would really appreciate some clarification! I am a little confused about why beta is lauded as the go-to measure of an individual stock's systemic/market risk. As I understand it, an individual stock's market risk is quantifiable as the magnitude of the effect that a market movement has on the individual stock's returns. This is separate from the specific risk unique to each individual stock. A combination of specific and market risks will then result in the observed volatility in an individual stock's returns. Then beta gauges a stock's market risk by measuring the covariance of individual stock returns and market returns divided by variance of market returns. This value is based on the volatility of the individual stock's returns as much as the market's, and as such is influenced by both the specific and systemic risk of a stock. I can't see how the specific risk is factored out in the beta calculation, and so I can't see how beta is a reliable measure of market risk.
For ex. A specific upwards pressure could be applied to a stock during an overall market return upswing, such that the stock's covariance with the market is overstated and market risk is overestimated if using beta.
I understand that in all likelihood i have a fundamental misconception about beta, but I am not quite able to find the misconception. Please lend a hand if you could!
It's based on the notion that a fully diversified portfolio should only be exposed to systemic risk (ridiculous i know).
I think you're asking about idiosyncratic risk? The theory is that it has no correlation with general market risk hence it is not captured when you simply measure the covariance of a stock's return with that of the general market.
I think the most important part of this post was your 2nd sentence. Perhaps beta isn't that great of a measure and that's why you're having trouble rationalizing :)
I do think you may want to be careful with what you're describing as systemic risk vs. what I think you meant to address (idiosyncratic risk). Idiosyncratic (stock specific) risk is assumed to be uncorrelated with the market so the beta calculation doesn't attempt to measure or adjust for this.
If you're feeling bold, you can develop a more complex beta calculation that doesn't assume idiosyncratic risk is entirely uncorrelated with the market.
I'm not sure if I understand what you're asking right, but a stock's movement on any given day is driven partially by market factors and partially by idiosyncratic factors for that individual stock. Over time, presumably the idiosyncratic factors will cancel out, so if you regress the stock movements on the market movements, you'll see an average over time, which is Beta.
If you look at the R-squared of that regression, you'll see how much of the movement of the stock is explained by the market factor.
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