17 August 2010
Hi, Was just wondering if cost of equity can be less than risk free rate? If yes,when and how? I can understand that one of the possibilities can be having a negative beta. when can the beta be negative?
17 August 2010
Beta is a statistical measure for risk. The total risk of any investment is comprised of diversifiable risk and non-diversifiable risk. The former arises from some conditions peculiar to an industry or a firm, such as management perceptions and changes, labour changes, regulatory actions etc.,. Diversifiable risk can be eliminated by holding enough stock of the shares concerned. Non-diversifiable risk arises from conditions external to an industry or firm and can be attributed to war, inflation, political and sociological events, which impact all investments alike and are not unique to any one particular industry or firm. These are also called systematic risks and cannot be eliminated. The equation goes thus: Total risk = Diversifiable risk+Nondiversifiable risk A high witted investor can rid his investment portfolio of diversifiable risk, totally, by holding a large enough portfolio of securities. Research confirms that by carefully selecting as few as fifteen securities for a portfolio, diversifiable risk can be done away with entirely. That leaves the other kind of risk, and the only kind, to be concerned with, as this is not of the type that can be eliminated. Each security carries with it, its own level of nondiversifiable risk, which is measured using the beta coefficient. Beta throws light on how the price of a given security reacts to market forces of demand and supply. Higher the responsiveness of a price of a security to market events, higher is the beta of the secuirty. When we relate the returns on a security with the returns for the market, on an average, we are calculating its beta coefficient, in effect. Market return is measured, by the average return of a large number of selected stocks, in other words, by the market index, such as Nifty and Sensex. The beta for the overall market is 1.00 and the betas for individual securities are calculated with reference to this value. Needless to say that betas can be both positive and negative. Beta can be extremely helpful in measuring systematic risk. It helps one understand the impact of market events on the return that a share or security is expected to fetch. If one can predict that the market is gonna get a 10 percent average return over the next one year, then a stock with a beta of 1. 75 will fetch one returns at 17.5%, over the same period. Here beta gives a picture of the higher volatility of the security. The risk lies in the fact that negative expectations about returns in the market, will cause the secuirity with higher than market beta to fetch far less returns than the market average. In the above example the stock would result in -17.5% returns where as the market average is only -10%. A stock having negative beta corresponds to the stock not being responsive to market fluctuations and changes and is therefore less risky. We use CAPM(Capital Asset Pricing Model) to understand the relationship between return and risk in an investment decision. CAPM assesses the impact of an investment in a particular secuirty on the return and risk of the portfolio as a whole. CAPM makes use of beta coefficient to relate risk to return for a security. CAPM calculates the required return on a secuirity using the equation:
Rs = Rf + Bs(Rm-Rf)
where : Rs = the return on the proposed security S Rf = the return supposed to be earned by a risk free security( Govt Bond) Rm= the average return of the market (Nifty Index) Bs = Coefficient of beta of the Security S Thus the return increases , as the beta increases.
The basic concept is that Beta can be negative when the particular security is behaving revers the market. In practically it is not possible.
In practical life cost of equity can not be less than risk free return. because cost of equity includes risk free+ risk premium. I think u got ur answer.
CAclubindia
