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ë The beta coefficient

ë The linear regression approach to beta
measurement using historical return data
± Normalizing the data
± Normalized holding period returns
± Running the regression using MS Excel
± Relevant regression statistics and their
interpretation
± Different regression charts


  

ë Gnder the theory of the Capital Asset Pricing Model total risk is
partitioned into two parts:
± Systematic risk
± Gnsystematic risk

 
O   

Systematic Risk Gnsystematic Risk

ë Systematic risk is the only relevant risk to the diversified

investor
ë The beta coefficient measures systematic risk

    
 
ë èhat does the term ³relevant 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
± èhen 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
relevant«hence investors are only rewarded for systematic
risk«risk that can be diversified away IS«and prices and returns
reflect ONLY systematic risk.

     



 


ë Each investor varies in the percentage of total risk that is

systematic
ë Some stocks have virtually no systematic risk.
± Such stocks are not influenced by the health of the economy in
general«their financial results are predominantly influenced by
company-specific factors
± An example is cigarette companies«people consume cigarettes
because they are addicted«so it doesn¶t matter whether the
economy is healthy or not«they just continue to smoke
ë 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

   

 
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A You need to gather historical data about the stock and the market
A You can use annual data, monthly data, weekly data or daily data.
A You need at least thirty (
) observations of historical data.
A opefully, the period over which you study the historical returns of the
stock is representative of the normal condition of the firm and its
relationship to the market.
A If the firm has changed fundamentally since these data were produced
(for example, they have merged with another firm or have divested
itself of a major subsidiary) there is good reason to believe that future
returns will not reflect the past«and this approach to beta estimation
S OGLD NOT be used«.rather, use the ex ante approach.
  

 
 

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ë The characteristic line is a regression line that represents the

relationship between the returns on the stock and the returns on the
market over a period of time.
ë The    



    is the Beta Coefficient
ë The degree to which the characteristic line explains the variability in the
dependent variable (returns on the stock) is measured by the
coefficient of determination. (also known as the ! (r-squared or
coefficient of determination)).
ë If the coefficient of determination equals 1. , this would mean that all
of the points of observation would lie on the line. This would mean that
the characteristic line would explain 1  of the variability of the
dependent variable.
ë The


is the vertical intercept of the regression (characteristic line).
Many stock analysts search out stocks with high alphas.



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ë An Ri that approaches 1. (or 1 ) indicates that the

characteristic (regression) line explains virtually all of the
variability in the dependent variable.
ë This means that virtually of the risk of the security is
µsystematic¶.
ë This also means that the regression model has a strong
predictive ability. « if you can predict what the market will
do«then you can predict the returns on the stock itself with a
great deal of accuracy.



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ë Examples of this type of risk include:

± a single company strike
± a spectacular innovation discovered through the company¶s R&D
program
± equipment failure for that one company
± management competence or management incompetence for that
particular firm
± a jet carrying the senior management team of the firm crashes
± the patented formula for a new drug discovered by the firm.
ë Obviously, diversifiable risk is that unique factor that influences
only the one firm.
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ë A common source for stock of information is Yahoo.com

ë You will also need to go to the library a use the TSE Review (a
monthly periodical)
ë You want data for at least
months.
ë For each month you will need:
± Ending stock price
± Number of shares outstanding for the stock
± Dividend per share paid during the month for the stock
± Ending value of the market indicator series you plan to use (ie.
TSE
composite index)
   
 
 
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The following slides will

be based on Alcan
Aluminum (AL.TO)
± *
  

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± *

Process:
± Go to http://ca.finance.yahoo.com
± Gse the symbol lookup function to search for the
company you are interested in studying
± Gse the historical quotes button«and get

months of historical data
± Gse the download in spreadsheet format feature
to save the data to your harddrive




± *

The raw downloaded data should look like this:

ate en Hi h ow lose Volu e

0 a 02 57 46 62 39 56 6 59 22 753874
0 r 02 62 9 63 6 56 25 57 9 8792 0
0 ar 02 64 9 66 8 6 68 63 03 974368
0 e 02 6 65 65 67 58 75 64 86 836373
02 Jan 02 57 5 62 37 54 93 6 85 989030
03 e 0 56 6 60 49 55 2 57 5 833280
0 o 0 49 58 02 47 08 56 69 779509




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The raw downloaded data should look like this:


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0 a 02 57 46 62 39 56 6 59 22 753874
0 r 02 62 9 63 6 56 25 57 9 8792 0

olume of
O ening rice er share, the trading done
The da , highest rice er share during the in the stock
month and month, the lowest rice er share on the TSE in
ear achieved during the month and the the month in
closing rice er share at the end numbers of
of the month board lots




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From Yahoo, the only information you can use is the

closing price per share and the date. ust delete the
other columns.


 
ay .
pr .
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In addition to the closing price of the stock on a per share basis,

you will need to find out how many shares were outstanding at
the end of the month and whether any dividends were paid
during the month.

You will also want to find the end-of-the-month value of the

S&P/TSX Total Return Composite Index (look in the green
pages)

You will find all of this in 
 
 periodicals ( G

1 .T T ) found on the second floor of the library.

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ë If you haven¶t already«go to the tools

menu«down to add-ins and check off the
BA Analysis Pac
ë èhen you go back to the tools menu, you
should now find the Data Analysis bar, under
that find regression, define your dependent
and independent variable ranges, your
output range and run the regression.
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ë You can use the charting feature in Excel to

create a scatter plot of the points and to put a
line of best fit (the characteristic line) through
the points.
ë Finally, you will want to interpret the Beta (X-
coefficient) the alpha (vertical intercept) and
the coefficient of determination.



ë Obviously the beta (X-coefficient) can simply

be read from the regression output.
ë You will want to interpret it in the context of
the firms, its products and the likely
relationship that they hold with the health of
the overall market.