11/7/2011

How to Estimate Betas of Stocks. Portfolio Analysis.

Last time
How to estimate beta of a stock using regression. How R-squared measures the proportion of systemic and idiosyncratic risks. How to interpret alpha.

GE
Model 5 Dependent variable: RP_GE VARIABLE const RP_SP COEFFICIENT 0.000855263 0.905579 STDERROR 0.00487055 0.123376 T STAT 0.176 7.340 P-VALUE 0.86099 <0.00001 ***

Mean of dependent variable = -6.14274e-005 Standard deviation of dep. var. = 0.0591219 Unadjusted R-squared = 0.369323

Interpretation: GE is significantly correlated with the market. Whenever market risk premium increases by 1%, GEs risk premium increases by 0.9056%. 36.93% of variation in GEs returns are due to the market the rest is idiosyncratic risk.

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GE
y = 0.0009 + 0.9056x R = 0.3693 50.000%

40.000% 30.000%
20.000% 10.000% 0.000% -15.00% -10.00%

-5.00% 0.00% -10.000% -20.000% -30.000% -40.000%

GE Risk Pr
5.00%

60.000%

10.00%

15.00%

Market Risk Premium

CAPM
For a diversified investor, beta measures a stocks contribution to portfolio risk. Beta, not variance, is the appropriate measure of risk. If you are holding market portfolio (the of your portfolio=1)
adding the stock with >1 to your portfolio, will increase the amount of risk for your portfolio; adding the stock with <1 to your portfolio, will decrease the amount of risk for your portfolio;

The required return on a stock equals:

Expexted[RetStock] = (Risk-Free Rate) + RPMarket

Example
Using monthly returns from 1990 2001, you estimate that Microsoft has a beta of 1.49 and Gillette has a beta of 0.81. If these estimates are a reliable guide for their risks going forward, what rate of return is required for an investment in each stock? E[RetStock] = Risk-Free Rate + RPMarket Market risk premium is around 4 6%. Risk-free rate around 1% Expected returns:
Gillette: E[RETGS] = 0.01 + (0.81 0.06) = 5.86% Microsoft: E[RETMSFT] = 0.01 + (1.49 0.06) = 9.94%

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To sum up CAPM
Standard deviation measures how much returns of an asset fluctuate around the average but it DOES NOT measure correlation with the market. Standard deviation measures overall risk. It does not distinguish between systematic and idiosyncratic risk. Beta measures CO-MOVEMENT of a stock return with the market but it does not measure OVERALL risk. OVERALL RISK = RISK DUE CO-MOVEMENT WITH THE MARKET + IDIOSYNCRATIC (STOCK-SPECIFIC) RISK R2 measure proportion of market risk in the overall risk.

Portfolio Analysis

Descriptive Statistics are not Enough

3.1

X Average Median S.D. Skew Kurt q1 Q3 IQR 2.54 2.56 0.30 -0.20 -1.15 2.30 2.78 0.48

Y 2.50 2.50 0.30 0.00 -1.20 2.25 2.76 0.51

2.9

2.7

2.5

2.3

X Y

2.1

1.9

1.7

1.5 0 10 20 30 40 50 60

Recall this example: Time is on horizontal axis, prices of hypothetical stocks X and Y are on vertical axis. Descriptive stats tell us that these two stocks are the same. But we can see that they have very different dynamics: One is perfectly predictable and one is not predictable at all. Also, the two stocks are not correlated.

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Covariance
Covariance is a measure of how much the variables (in our class that will be typically stock returns) move up and down together. The formula for covariance is
Cov( X , Y )

x1 x y1 y x2 x y2 y ... xn x yn y
n

Cov( X , Y )
i 1

xi x yi y
n 1

n 1

Excel: =Covar(array1, array2)

Example
IBM HP IBM Monthly HP Monthly Date price returns price return 1/3/2000 105.16 38.32 2/1/2000 96.36 -8.37% 47.61 24.24% 3/1/2000 111.01 15.20% 46.98 -1.32% 4/3/2000 104.56 -5.81% 47.84 1.83% 5/1/2000 100.76 -3.63% 42.59 -10.97% 6/1/2000 102.87 2.09% 56.77 33.29% 7/3/2000 105.39 2.45% 49.67 -12.51% 8/1/2000 124.1 17.75% 54.85 10.43% 9/1/2000 105.86 -14.70% 44.17 -19.47% 10/2/2000 92.59 -12.54% 42.35 -4.12% 11/1/2000 88 -4.96% 28.79 -32.02% 12/1/2000 80 -9.09% 28.81 0.07% 1/2/2001 105.41 31.76% 33.64 16.77% 2/1/2001 94.13 -10.70% 26.34 -21.70% mean variance st.dev. IBM HP 0.506% 0.944% <-- =average(...) 0.008238 0.013444 <-- =var() 9.08% 11.60% <-- =stdev() 0.005022 <-- =COVAR(ret_hp,ret_ibm)

Covariance

Interpretation: Covariance is positive. When IBM price goes up, HP tends to go up as well.

Correlation
Correlation is a measure of how much the variables (in our class that will be typically stock returns) move up and down together.
Corr ( X , Y ) Cov( X , Y )

XY

Dividing covariance by standard deviations gets rid of units of measurement: While covariance depends on units, correlation is unit-less. While covariance measures the direction of comovement, correlation measure direction AND strength. Excel: =Correl(array1, array2)

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Comparing Covariance and Correlation

Correlation is ALWAYS between -1 and 1.
If Corr= -1, the two variables are perfectly negatively correlated. If Corr= 1, the two variables are perfectly positively correlated. If Corr=0, the two variables are not correlated.

Covariance can take on any value. If covariance is zero, the two variables are not correlated. For both Correlation and Covariance, order does not matter:
Cov(X,Y)=Cov(Y,X) Corr(X,Y)=Corr(Y,X)

Example
IBM HP IBM Monthly HP Monthly Date price returns price return 1/3/2000 105.16 38.32 2/1/2000 96.36 -8.37% 47.61 24.24% 3/1/2000 111.01 15.20% 46.98 -1.32% 4/3/2000 104.56 -5.81% 47.84 1.83% 5/1/2000 100.76 -3.63% 42.59 -10.97% 6/1/2000 102.87 2.09% 56.77 33.29% 7/3/2000 105.39 2.45% 49.67 -12.51% 8/1/2000 124.1 17.75% 54.85 10.43% 9/1/2000 105.86 -14.70% 44.17 -19.47% 10/2/2000 92.59 -12.54% 42.35 -4.12% 11/1/2000 88 -4.96% 28.79 -32.02% 12/1/2000 80 -9.09% 28.81 0.07% 1/2/2001 105.41 31.76% 33.64 16.77% 2/1/2001 94.13 -10.70% 26.34 -21.70% IBM HP 0.506% 0.944% <-- =average(...) 0.008238 0.013444 <-- =var() 9.08% 11.60% <-- =stdev() 0.005022 <-- =COVAR(ret_hp,ret_ibm) 0.482466 <-- =CORREL(ret_hp,ret_ibm)

mean variance st.dev.

Covariance Correlation

Statistics of Portfolios
Suppose you tale $X and invest it in a number of stocks. If we know statistical properties of individual stocks, what can we learn about the statistical properties of a portfolio of these stocks?
What is the average return of the portfolio? S.d. of portfolio? Beta of the portfolio?

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Statistics of Portfolios Simplest case: Two uncorrelated stocks

You can invest in Stocks A and B:
A: avg. return = 5% and s.d = 10% B: avg. return = 6% and s.d. =13% Correlation between two stocks is 0

Suppose you choose to split your portfolio equally between the two stocks. The average return on your portfolio will be

Avg.Ret = wArA + wBrB = 0.5*5% + 0.5*6% = 5.5%

The Standard deviation of your portfolio is (a little) harder to calculate:
First calculate the VARIANCE of the portfolio:

Var(Portfolio) = (wA)22A + (wB)22B = 0.52*(10%)2 + 0.52*(13%)2 = 67.25

Then, take the square root of the variance: =SQRT(67.25) = 8.2% This is the s.d. of portfolio

Statistics of portfolios: Variance of portfolio with two correlated stocks

There are two stocks A and B. Their mean returns are A and B, respectively. The standard deviations of returns are A and B The two stocks are correlated and the correlation coefficient is . Suppose you create a portfolio by taking X dollars and investing them into these two stocks: (it has to be true that wA=1-wB), A B The mean return of the portfolio is

X=w X + w X

X = wAA + wBB
The variance of the portfolio return is Standard deviation of portfolio return is the square root of the variance. For more information, see http://www.onlinestatbook.com/chapter3/transformations.html http://www.onlinestatbook.com/chapter3/variance_sum_law.html http://www.onlinestatbook.com/chapter4/variance_sum_law2.html

2X = (wA)22A + (wB)22B + 2(wA)(wb)AB

Simple case: Two correlated stocks

You can invest in Stocks A and B:
A: avg. return = 5% and s.d = 10% B: avg. return = 6% and s.d. =13% Correlation between two stocks is 0.4

Suppose you choose to split your portfolio equally between the two stocks. The average return on your portfolio will be

0.5*5% + 0.5*6% = 5.5%

The Standard deviation of your portfolio is (a little) harder to calculate:
First calculate the VARIANCE of the portfolio:

Var(Portfolio) = 0.52*(10%)2 + 0.52*(13%)2 + +2*0.4*0.5*0.5*10%*13%= 93.25

Then, take the square root of the variance: =SQRT(93.25) = 9.66% This is the s.d. of portfolio

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Portfolio Risk depends on correlation of assets in the portfolio.

Here are a few examples of how s.d. of the portfolio depends on correlation between the stocks. These examples were calculated using the same means and standard deviations of the A and B stocks as in the previous two examples. The only thing that varies is the correlation:
=1 =0.9 =0.7 =0.4 =0 =-0.5 =-1 s.d. = 11.50 s.d. = 11.21 s.d. = 10.62 s.d. = 9.66 s.d. = 8.20 s.d. = 5.89 s.d. = 1.50

The lower is the correlation between the two stocks, the _______ is the benefit from diversification.