Finance

Adjusted Beta

Adjusted Beta

The beta is a measure that shows how an individual asset moves when the overall stock market increases or decreases. Basically, it is a numeric value that measures the fluctuations of a stock to changes in the overall stock market. Beta is used in Capital Asset Pricing Model which helps in describing the relationship between systematic risk and expected returns.

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Beta = Variance/ Covariance

Explain what is Adjusted Beta?:

Adjusted beta helps in estimating a securities future beta. It is a historical beta adjusted to reflect the tendency of a beta. It assumes that securities’ true beta will move towards a market average of 1 over time.

How it is estimated?:

Vasicek adjusted past betas towards the average beta by modifying each data. In the historic period if the average beta across sample stock is B1, then the Vasicek technique involves taking a weighted average of B1 and historic beta of security.

Adjusted Beta = Regression Beta * (0.67) + 1.00 * (0.33)

Adjusted Betas and CAPM:

Beta is a measure of systematic risk, that refers to the risk inherent to the overall financial market. CAPM depicts a linear relationship between the expected return for an asset and the beta. It is measured by the covariance of an investment’s return with returns of the market.

Why adjust betas towards one?:

Beta has mean-reverting property because of which the adjusted beta will move closer to 1.  Betas of all companies tend to converge towards 1. It is because large companies tend to grow in size, become more diversified and own more assets over time because their beta values fluctuate less.

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Conclude:

Beta measures the risk added on a diversified portfolio and is always centered around one. The beta of a stock can be presented as Adjusted beta or Raw beta. It is obtained from linear regression to stock historical data.

Author: Urvi Surti

About the Author:

Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).

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