Measuring the Ex Ante Beta

2039

Calculating a Beta Coefficient Using

Ex Ante Returns

Ex Ante means forecast

You would use ex ante return data if historical rates
of return are somehow not indicative of the kinds of
returns the company will produce in the future.
A good example of this is Air Canada or American
Airlines, before and after September 11, 2001. After
the World Trade Centre terrorist attacks, a
fundamental shift in demand for air travel occurred.
The historical returns on airlines are not useful in
estimating future returns.

In this slide set

The

beta coefficient
The formula approach to beta measurement
using ex ante returns

Ex ante returns
Finding the expected return
Determining variance and standard deviation
Finding covariance
Calculating and interpreting the beta coefficient

The Beta Coefficient

Under the theory of the Capital Asset Pricing Model total risk is
partitioned into two parts:

Systematic risk
Unsystematic risk
Total Risk of the Investment

Systematic Risk

Unsystematic Risk

Systematic risk is the only relevant risk to the diversified

investor
The beta coefficient measures systematic risk

The Beta Coefficient the formula

Covariance of Returns between the stock and the market

Variance of the Market Returns
Cov(R s R M )
Beta
Var(R M )
Beta

The Term Relevant Risk

What does the term relevant risk mean in the context of the CAPM?
It is generally assumed that all investors are wealth maximizing risk
averse people
It is also assumed that the markets where these people trade are
highly efficient
In a highly efficient market, the prices of all the securities adjust
instantly to cause the expected return of the investment to equal
the required return
When E(r) = R(r) then the market price of the stock equals its
inherent worth (intrinsic value)
In this perfect world, the R(r) then will justly and appropriately
compensate the investor only for the risk that they perceive as
relevanthence investors are only rewarded for systematic risk
risk that can be diversified away ISand prices and returns reflect
ONLY systematic risk.

The Proportion of Total Risk that is

Systematic

Each investor varies in the percentage of total risk that is

systematic
Some stocks have virtually no systematic risk.

Such stocks are not influenced by the health of the economy in

generaltheir financial results are predominantly influenced by
company-specific factors
An example is cigarette companiespeople consume cigarettes
because they are addictedso it doesnt matter whether the
economy is healthy or notthey just continue to smoke

Some stocks have a high proportion of their total risk that is

systematic

Returns on these stocks are strongly influenced by the health of

the economy
Durable goods manufacturers tend to have a high degree of
systematic risk

The Formula Approach to Measuring

the Beta

Cov(R s R M )
Beta
Var(R M )
You need to calculate the covariance of the returns between the stock
and the marketas well as the variance of the market returns. To
do this you must follow these steps:
Calculate the expected returns for the stock and the market
Using the expected returns for each, measure the variance
and standard deviation of both return distributions
Now calculate the covariance
Use the results to calculate the beta

Ex ante return data (a sample)

An set of estimates of possible returns and their respective
probabilities looks as follows:

The Total of the Probabilities must

equal 100%
This means that we have considered all of the possible outcomes in
this discrete probability distribution

Measuring Expected Return on the

stock From Ex Ante Return Data
The expected return is weighted average returns from
the given ex ante data

Measuring Expected Return on the

market From Ex Ante Return Data
The expected return is weighted average returns from
the given ex ante data

Measuring Variances, Standard

Deviations from Ex Ante Return Data
Using the expected return, calculate the deviations away from the mean, square
those deviations and then weight the squared deviations by the probability of
their occurrence. Add up the weighted and squared deviations from the mean
and you have found the variance!

Measuring Variances, Standard

Deviations from Ex Ante Return Data
Now do this for the possible returns on the market

Covariance
The formula for the covariance between the returns on the stock and the
returns on the market is:
n

Cov ( Rs RM ) Pt ( Rs R s )( RM R m )
t 1

Covariance is an absolute measure of the degree of co-movement of

returns. The correlation coefficient is also a measure of the degree of
co-movement of returnsbut it is a relative measurethis is why it is
on a scale from +1 to -1.

Correlation Coefficient
The formula for the correlation coefficient between the returns on the
stock and the returns on the market is:

Cov ( Rs RM )
Corr ( Rs RM )
s M
The correlation coefficient will always have a value in the range of +1 to
-1.

Measuring Covariances and Correlation

Coefficients from Ex Ante Return Data
Using the expected return (mean return) and given data measure the
deviations for both the market and the stock and multiply them
together with the probability of occurrencethen add the products up.

The Beta Measured Using

Ex Ante Return Data
Now you can plug in the covariance and the variance of the
returns on the market to find the beta of the stock:

Cov(R s R M ) .01335
Beta

1.8
Var(R M )
.007425
A beta that is greater than 1 means that the investment is
aggressiveits returns are more volatile than the market as a whole.
If the market returns were expected to go up by 10%, then the stock
returns are expected to rise by 18%. If the market returns are
expected to fall by 10%, then the stock returns are expected to fall by
18%.

Lets Prove the Beta of the Market is 1.0

Let us assume we are comparing the possible market
returns against itselfwhat will the beta be?

Since
Sincethe
thevariance
varianceofofthe
thereturns
returnson
onthe
themarket
marketisis==.007425
.007425the
thebeta
beta
for
forthe
themarket
marketisisindeed
indeedequal
equalto
to1.0
1.0!!!!!!

Proving the Beta of Market = 1

If you now place the covariance of the market with
itself value in the beta formula you get:

Cov(R M R M ) .007425
Beta

1.0
Var(R M )
.007425

How Do We use Expected and

Required Rates of Return?

Once you have estimated the expected and required rates of

return, you can plot them on a SML and see if the stock is
under or overpriced.
% Return

E(R) = 5.0%

R(RX) = 4.76%

SML

E(RM)= 4.2%

Risk-free Rate = 3%

BM= 1.0

BX =
1.464

Since E(r)>R(r) the stock is underpriced.

How Do We use Expected and

Required Rates of Return?

The stock is fairly priced if the expected return = the required

return.
This is what we would expect to see normally or most of the
time.
% Return
E(RX) = R(RX) 4.76%

SML

E(RM)= 4.2%

Risk-free Rate = 3%

B M=
1.0

BX = 1.464

Use of the Forecast Beta

We can use the forecast beta, together with an estimate of the risk-free
rate and the market premium for risk to calculate the investors
required return on the stock using the CAPM:

Required Return R f j [E (rM ) R f ]

Conclusions

Analysts can make estimates or forecasts for the

returns on stock and returns on the market portfolio.
Those forecasts can be analyzed to estimate the
beta coefficient for the stock.
The required return on a stock can be calculated
using the CAPM but you will need the stocks beta
coefficient, the expected return on the market
portfolio and the risk-free rate.