Graduating in Risk Premium

In case you have reached this vantage point after having understood the basics of 'risk premium', we offer you our hearty congratulations on having made such outstanding progress!

Now, picking up the thread from where we left off, investors get compensated only for the market risk that they bear. Market risk is the only risk that cannot be reduced through diversification in your portfolio (by including a set of stocks from different businesses), like business risk can.

However, the influence of the market varies for various stocks. Some stock movements are exaggerated compared with market movements while others are subdued.

We understood last time that the 'beta' of a stock measures this relative movement of a stock vis-?is the market. Hence, 'beta' measures the tendency of the stock to participate in the market movement.

Let's work this out using an example...

Hyper Ltd., Tracker Ltd. and Sober Ltd. are three stocks that trade in the stock market of Shareland. Sharex is the stock market index in Shareland. Hyper has a beta of 1.3 while Tracker has a beta of 1. On the other hand, Sober has a beta of 0.7.

First stop, what do these values mean?

Hyper's beta value of 1.3 indicates that it is far more sensitive to market movements than Tracker and Sober. In other words, if the market as measured by Sharex goes up by 10%, Hyper will go up by 13%. Tracker will go up as much as the market, i.e. 10%, while Sober gains a mere 7% in relation to the market.

Who commands the lower risk premium?

After having come so far in the lesson, we expect that you will flip this situation to its negative face and look at the situation when the stock market in Shareland drops by 10%.

In this case, Hyper drops the most (by 13%) as it has a higher beta of 1.3. Since Tracker has a beta of 1, it drops by 10%, the same as the market. On the other hand, Sober drops by a mere 7%.

A higher beta means higher risk and hence a stock with higher risk needs to command a higher 'risk premium'. And obviously, since Hyper reacts in a manner true to its name for every drop/gain in the market, it is the riskiest stock and should command the highest premium, followed by Tracker with Sober being the least risk option of the three.

Moving on to CAPM

So if the risk premium commanded by the stock market is x%, then the risk premium that investors should demand for a particular stock is beta times x%. CAPM states that the expected return on a stock is the sum of a `risk-free rate' and `stock beta times market risk premium'.

This, in essence, is the capital asset pricing model (CAPM). After all, why should anyone expect to earn more by investing in one stock as opposed to another? You need to be compensated for doing badly when times are bad. The stock that is wont to do badly just when you need money in trying times is a stock you should hate, and there had better be some redeeming virtue or else who would want to hold it?

How is beta calculated?

Oh, we are not going to give you some longwinded formula. After all these days, you do not need to know how a computer works to actually use one. So, we shall never trouble you with formulae, but just explain the concept.

An analyst calculating the beta of a stock obtains the historical returns of that stock over a period and then compares them using 'linear regression' to the returns on the index. It is just enough for most of us to know that linear regression is a statistical tool for estimating beta.

Some pertinent questions to ask at this stage

Q: Is the beta of a stock constant?

A: The beta of a stock can change over time as the stock's characteristics transform. For example, a stock moving from the B1 group to the A group sometime back would have changed the beta of the stock. After all, the underlying liquidity of the stock would have changed as A group stocks have this carry forward mechanism that attracts a whole host of speculators.

Q: Can a low beta stock be more volatile than a high beta stock?

A: Interestingly, a low beta stock could be more volatile than a high beta stock. Remember, the beta measures only the systemic risk or the influence of the market on the stock whereas a stock on its own might have a very high unsystemic risk because of the risk associated with the company's business.

Wrapping up today's spoils

The key insight of the capital asset pricing model is that higher expected returns go with the greater risk of doing badly in bad times.

Beta is a measure of a stock's tendency to move with the market. Stocks with high betas tend to do worse in market downturns than those with low betas.

Our advice: If your heart has a high beta level, invest in a stock that has a low beta!