Concept of Beta, Classification of Beta-Geared and Ungeared Beta
The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.
The beta coefficient can be interpreted as follows:
- β =1 exactly as volatile as the market
- β >1 more volatile than the market
- β <1>0 less volatile than the market
- β =0 uncorrelated to the market
- β <0 negatively correlated to the market
Examples of beta
High β: A company with a β that’s greater than 1 is more volatile than the market. For example, a high-risk technology company with a β of 1.75 would have returned 175% of what the market return in a given period (typically measured weekly).
Low β: A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a given period.
Negative β: A company with a negative β is negatively correlated to the returns of the market. For an example, a gold company with a β of -0.2, which would have returned -2% when the market was up 10%.
Equity Beta and Asset Beta
Levered beta, also known as equity beta or stock beta, is the volatility of returns for a stock taking into account the impact of the company’s leverage from its capital structure. It compares the volatility (risk) of a levered company to the risk of the market.
Levered beta includes both business risk and the risk that comes from taking on debt. It is also commonly referred to as “equity beta” because it is the volatility of an equity based on its capital structure.
Asset beta, or unlevered beta, on the other hand, only shows the risk of an unlevered company relative to the market. It includes business risk but does not include leverage risk.