An investor is concerned with the risk of his entire investment portfolio, and that the relevant risk of a particular security is the effect that the security has on the entire portfolio. By “diversified portfolio” we mean that each investor’s portfolio is representative if the market as a whole and that the portfolio Beta is 1.0. Stock’s Beta indicate how closely the security’s returns move with from a diversified portfolio. A beta of 1.0 for a given security means that, if the total value of securities in the market moves up by 10 percent, the stock’s price will also move up, on the average by 10 percent. If security has a beta of 2.0, its price will, on the whole, rises or falls by 20 percent when the market rises or falls by 10 percent. A share with —0.5 percent beta will rises by 10 percent, when the market falls by 20 percent.
A beta of any portfolio of securities is the weighted average of the betas of the securities, where the weights are the proportions of investments in each security. Adding a high beta (beta greater than 1.0) security to a diversified portfolio increase the portfolio’s risk, and adding a low beta (beta less than zero) security to a diversified security reduces the portfolio’s risk.
The stock’s beta co-efficient can be found by examining security’s historical returns relative to the return of the market. As it is, not feasible to take all securities, a sample of securities is used. The Capital Asset Pricing Model (CAPM) uses these beta co-efficients to estimate the required rate of return on the securities. The CAPM, specifies that the required rate on the share depends upon its beta. The relationship is :
Ke = Riskless rate + Risk premium x Beta
where, Ke = expected rate of return.
The current rate on government securities can be used as a riskless rate. The difference between the long-run average rate of returns between shares and government securities may represent the risk premium. Beta co-efficient are provided by the published date or can be independently estimated.
The use of beta to measure the cost of equity capital is definitely a better approach. The major reason is that the method incorporates risk analysis, which other methods do not. However, its application remains limited perhaps because it is tedious to calculate stock’s beta value.