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Beta is a
risk metric employed
primarily in the equity markets. It measures the
systematic risk of a
single instrument or an entire portfolio. William Sharpe (1964)
first used the notion in his landmark paper introducing the
capital asset
pricing model (CAPM). The name "beta" was applied later.
Beta describes the sensitivity of an instrument or portfolio to broad
market movements. The stock market (represented by an index such as the
S&P 500 or FT-100) is assigned a beta of 1.0. By comparison, a portfolio
(or instrument)
which has a beta of 0.5 will tend to participate in broad market moves,
but only half as much as the market overall. A portfolio (or instrument) with a beta of
2.0 will tend to benefit or suffer from broad market moves twice as much
as the market overall.
The formula for beta is.
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where
  is the
covariance between the portfolio (or instrument)
return and the market
return, and
is the variance of the market's return (volatility squared).
Both quantities are calculated using simple returns. Beta is generally estimated from historical price
time series. For
example, 60 trading days of simple returns might be used with sample
estimators for covariance and variance.
It is possible to construct negative beta portfolios. Approaches
include
holding
stocks (such as gold mining stocks) that tend to move against the market,
shorting stocks, or
putting on suitable options spreads.
Beta is sometimes used as a metric of a portfolio's
market risk. This can be
misleading because beta does not capture
specific risk. Because of
specific risk, a portfolio can have a low beta but still be highly volatile. Its price fluctuations will simply have a low
correlation with
those of the overall market.
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 alpha If active investment
management were a religion, alpha would be its god.
capital asset pricing
model—a model for asset pricing and portfolio construction.
capital market line—a
set of portfolios obtainable by leveraging or de-leveraging
positions in a "super-efficient" portfolio.
efficient frontier—a
set of portfolios that each maximize expected return for a given
level of risk.
efficient market
hypothesis A financial theory that markets are efficient in the sense that
prices reflect all available information.
market risk Exposure to the uncertain market value of a portfolio.
portfolio theory—a body of
theory for how risk averse investors construct portfolios.
Sharpe
ratio, Treynor ratio Two risk-adjusted performance metrics
developed for testing the efficient market hypothesis and widely
used by investment managers since. |
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Ads by Contingency Analysis
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The following books discuss beta
from different perspectives. Bernstein (1993)
is a must-read history of finance during the 20th century. Body,
Kane and Marcus (2004)
is the standard university text on finance. For the practitioner's
perspective, see either Grinold and
Kahn (1999) or Fabozzi and Markowitz (2002).
All four books discuss beta. All are exceptional.
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Investments |
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Zvi Bodie, Alex Kane, Alan J. Marcus |
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quality |
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technical |
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2004 |
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 Sharpe, William
F. (1964). Capital asset prices: A theory of market equilibrium
under conditions of risk, Journal of Finance, 19 (3),
425-442. |
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