Negative Beta and cost of equity

[MURUGAVEL]

Dear Friends,

 

Recently I had an opportunity to discuss on Negative Beta and Cost of Equity with a friend with respect to a specific context.

 

Let us consider that we have a company A run by a bad management. The company has for the last few quarters been reporting bad results and its investors are dumping the shares in the market. During the same period the stock market has been booming - say the sensex increases from 8000 to 18000 etc. Suppose this firm wants to raise equity, what do you think will the cost of equity ? Can this situation be deemed as 'true' beta - and can the cost of equity for such a firm be below the risk free rate ?

 

My view:

To the best of my knowledge, this is not possible. Forget what people in New York or anywhere else say, I would not put in my money in such a company - when returns are below the risk free rate....This is not my idea of 'insurance' either.

 

What do you think ?

 

Regards,

Murugavel

 

 

 

 

[Vikas Singh]

Dear Sir & Friends,

 

Although this is very lengthy mail, but I would like to have your opinion/criticism on this. Therefore, I am sending this....

 

There was a discussion on how come the cost of equity fo a negative beta company can be less than risk free rate...

 

For the sake of explanation, lets take investment into short selling of market index. This asset will give negative return when market is going up but when the market goes down this will give positive return which will be more than the risk free return also. Although it is difficult to find out a company having such contrasting fundamentals nevertheless if one can find such stock then that company will certainly have lower cost of equity during the period when market is giving positive market premium (similarly the company will have higher cost of equity when the market premium is negative).

 

Compare this situation with insurance. When you are young and healthy and don't expect to die soon. The return from a pure life insurance will be negative or atmost very low. Because you will be getting return from other gainfull activities. However, when you become unhealthy or die, the return from the gainfull acitivities decline and become negative at that point of time the return from insurance becomes positive or higher than the risk free return.

Therefore, it can be said that a company with negative beta will have lower cost of equity when the market premium is positive but when the market premium goes negative the cost of equity again rises above the risk free rate. It seems difficult to digest (same way as in case of pure insurance investment) that how come the cost of equity is lower than the risk free rate. Because if it is lower than the risk free rate then investor can invest in those risk free instruments rather than these companies. However, it needs to be appriciated that

investment into negative beta assets protect you from the downside of market. Because when market goes down it is these assets which will provide some cushion and not the risk free investment.

One may argue that if market is upbeat and people are investing in the market than there will be scarcity of fund for negative beta companies as return is lower from these companies therefore it should become difficult for these companies to get equity at lower cost. However, the fact that needs to be appreciated over here is that the CAPM model which is used to calculate cost of equity is actually a model to calculate Expected return of the investor (understood same as Cost of equity, although it is still valid the perspecive changes with nominclature). The expected return from an investment depends on the investors expecations from the business. The investors in negative beta companies understand that the company will perform opposite to the market and hence it will give positive return only if market is going down whereas if market is going up than the stock will give lower returns and the investors are still willing to invest (understanding the fact that it will work like an insurance).

One important factor to understand is that a company's beta is a function of its performance compared to the performance of the market and not vice vesra. The company's fundamentals are such that when generally market does well that is when the economy is booming and returns from business in every sector goes up the returns from negative beta companies comes down and they make losses. Therefore, their return to equity holders also goes down and hence the negative beta.

Gold/pecious metal is a very good example of ngative beta asset. Genrally, the gold prices goes up when market goes down and vice versa. Problem is that there are very few companies which are fundamentally different than the market and hence it is difficult to appreciate this fact.

Vikas Kumar Singh

BIM Trichy, PGP26

+91-9344223111

--
You received this message because you are subscribed to the Google Groups "BIM_Finance" group.
To post to this group, send an email to BIM_F...@googlegroups.com.
To unsubscribe from this group, send email to BIM_Finance...@googlegroups.com.
For more options, visit this group at http://groups.google.com/group/BIM_Finance?hl=en-GB.

--
Vikas Kumar Singh
BIM, Trichy (26th Batch)

[ernest kirubakaran]

Dear Sir,

The beta we should use to calculate cost of equity is historic beta and not the beta for the last few quarters. If historic beta is negative for that stock, the stock price would have become zero long ago.

Also, I think we should use the absolute value of beta in the formula.  Can someone please throw some light on this?

Finally, no management would take the equity route to rise capital at a time when existing stockholders themselves are dumping the shares.

Regards,

S Ernest 

On Wed, Oct 27, 2010 at 12:56 PM, MURUGAVEL <murug...@bim.edu> wrote:

--

[MURUGAVEL]

Dear Vikas,

 

There is a clear context too ... The firm has a bad management + the beta is negative. Please discuss in this context. Agree that this many not be an opportune moment to raise equity - but one may never get debt in such an instance..

 

(I have no disagreement that in theory there can be a situtation when beta can be negative and if CAPM model is used for evaluating cost of equity, then it can be below the risk free rate ).

 

Regards,

Murugavel 

 

 
----- Original Message -----
From: "Vikas Singh" <vikas...@gmail.com>
To: "bim finance" <bim_f...@googlegroups.com>
Sent: Wednesday, 27 October, 2010 15:09:57 GMT +05:30 Chennai, Kolkata, Mumbai, New Delhi
Subject: Re: Negative Beta and cost of equity

Dear Sir & Friends,

 

Although this is very lengthy mail, but I would like to have your opinion/criticism on this. Therefore, I am sending this....

 

There was a discussion on how come the cost of equity fo a negative beta company can be less than risk free rate...

 

For the sake of explanation, lets take investment into short selling of market index. This asset will give negative return when market is going up but when the market goes down this will give positive return which will be more than the risk free return also. Although it is difficult to find out a company having such contrasting fundamentals nevertheless if one can find such stock then that company will certainly have lower cost of equity during the period when market is giving positive market premium (similarly the company will have higher cost of equity when the market premium is negative).

 

Compare this situation with insurance. When you are young and healthy and don't expect to die soon. The return from a pure life insurance will be negative or atmost very low. Because you will be getting return from other gainfull activities. However, when you become unhealthy or die, the return from the gainfull acitivities decline and become negative at that point of time the return from insurance becomes positive or higher than the risk free return.

Therefore, it can be said that a company with negative beta will have lower cost of equity when the market premium is positive but when the market premium goes negative the cost of equity again rises above the risk free rate. It seems difficult to digest (same way as in case of pure insurance investment) that how come the cost of equity is lower than the risk free rate. Because if it is lower than the risk free rate then investor can invest in those risk free instruments rather than these companies. However, it needs to be appriciated that

investment into negative beta assets protect you from the downside of market. Because when market goes down it is these assets which will provide some cushion and not the risk free investment.

One may argue that if market is upbeat and people are investing in the market than there will be scarcity of fund for negative beta companies as return is lower from these companies therefore it should become difficult for these companies to get equity at lower cost. However, the fact that needs to be appreciated over here is that the CAPM model which is used to calculate cost of equity is actually a model to calculate Expected return of the investor (understood same as Cost of equity, although it is still valid the perspecive changes with nominclature). The expected return from an investment depends on the investors expecations from the business. The investors in negative beta companies understand that the company will perform opposite to the market and hence it will give positive return only if market is going down whereas if market is going up than the stock will give lower returns and the investors are still willing to invest (understanding the fact that it will work like an insurance).

One important factor to understand is that a company's beta is a function of its performance compared to the performance of the market and not vice vesra. The company's fundamentals are such that when generally market does well that is when the economy is booming and returns from business in every sector goes up the returns from negative beta companies comes down and they make losses. Therefore, their return to equity holders also goes down and hence the negative beta.

Gold/pecious metal is a very good example of ngative beta asset. Genrally, the gold prices goes up when market goes down and vice versa. Problem is that there are very few companies which are fundamentally different than the market and hence it is difficult to appreciate this fact.

Vikas Kumar Singh

BIM Trichy, PGP26

+91-9344223111

On Wed, Oct 27, 2010 at 12:56 PM, MURUGAVEL <murug...@bim.edu> wrote:

Dear Friends,

 

Recently I had an opportunity to discuss on Negative Beta and Cost of Equity with a friend with respect to a specific context.

 

Let us consider that we have a company A run by a bad management. The company has for the last few quarters been reporting bad results and its investors are dumping the shares in the market. During the same period the stock market has been booming - say the sensex increases from 8000 to 18000 etc. Suppose this firm wants to raise equity, what do you think will the cost of equity ? Can this situation be deemed as 'true' beta - and can the cost of equity for such a firm be below the risk free rate ?

 

My view:

To the best of my knowledge, this is not possible. Forget what people in New York or anywhere else say, I would not put in my money in such a company - when returns are below the risk free rate....This is not my idea of 'insurance' either.

 

What do you think ?

 

Regards,

Murugavel

 

 

 

 

--
You received this message because you are subscribed to the Google Groups "BIM_Finance" group.
To post to this group, send an email to BIM_F...@googlegroups.com.
To unsubscribe from this group, send email to BIM_Finance...@googlegroups.com.
For more options, visit this group at http://groups.google.com/group/BIM_Finance?hl=en-GB.

--
Vikas Kumar Singh
BIM, Trichy (26th Batch)

--
You received this message because you are subscribed to the Google Groups "BIM_Finance" group.
To post to this group, send an email to BIM_F...@googlegroups.com.
To unsubscribe from this group, send email to BIM_Finance...@googlegroups.com.
For more options, visit this group at http://groups.google.com/group/BIM_Finance?hl=en-GB.

--
J.Murugavel
Bharathidasan Institute of Management
PB No 12, MHD Campus, BHEL Complex
Thiruchirapalli 620014
Hand phone: 93633 14015 / 96986 37776

[Sivaprakasam p]

Sir,

Its a nice thought. But I fear I cant understand the link between raising equity and cost of equity. The willingness (of an investor) to invest in a fund raising exercise may not be corelated with the expected rate of return.

There is a point though. Price discovery happens with performance and negative stock movement means that investors' expectation of returns is reducing. So over a period of time, a more negative beta would mean a reduction in expected rate of return. My opinion is, negative beta is a consequence of reducing enterprise value. Negative beta can not be an input to enterprise value. In this case, you are right Sir, beta is not true beta. But tends to alpha, since the figure is more company specific. But MRP itself is an approximation and broad based, probably, there is an assumption in CAPM that the performance of companies dont correlate negatively.

I read that in reality, we cant find a negative beta stock. Negative beta is applicable for liquidation companies.

A candid admittance is that I am too confused to think further. Have been deliberating on this for a long time. Further inputs appreciated.

Regards,
Sivaprakasam P
BIM 25

On Wed, Oct 27, 2010 at 12:56 PM, MURUGAVEL <murug...@bim.edu> wrote:

--

[Sivaprakasam p]

That was a nice angle Ernest. Two things here

1. In the scenario as proposed by Sir, if a company were to be producing bad results, the stock price would tend to stabilise after a period of time. This would make beta positive after sometime. In this case, the price fall would be restricted to only a short period of time.
2. Negative historic beta doesn't tend the stock price to zero. Think of market downside too.

Regards,
Siva

[MURUGAVEL]

Hi,

 

(Let me start with this : I have been on the debt side of biz for long and my knowledge of the equity side is passed on knowledge , which is basically what I have heard and learnt - the loss due to Lamarkianism  - recent developments that might have changed what was earlier considered correct + what I can think and understand. Basically a lay man's knowledge )

 

From a lay man's point of view ( i.e., my point of view) though they are different , expected return for an average investor from an investment in a firm will decide the cost of equity of equity of the firm. If an investment in a firm is not giving an investor a return that he expects for assuming that particular risk - I dont see him investing in a that firm. So, the investment happens when atleast the returns expected are provided by the firm . Which hence will be the cost that the firm incurs for the equity. Am I atleast approximately correct on this point ?

 

Like most ppl I have also not been able to find a negative beta stock yet - but I am making an assumption - if the management of the firm happens to be bad ( i.e they keep making bad decisions ) - consistently (that is not a big deal - quite of few of them actually manage to be consistent at that ) - and investors in that stock keep selling ( in a bull market) , then will not beta be negative ? We may say we will need to look at historic beta - let us assume that the contrary movement is long enough. The issues are - can this beta be true negative beta ?

 

Now for this firm, what will be cost of equity be ? Can we use CAPM model and say for this firm , the cost of equity will be less than the risk free rate.

 

And more importantly how can historic beta be used for making a decision on an future risk ? Isn't that itself a limitation of the CAPM model ?

 

Actually there are a few more issues - particularly pertaining to management quality. Let us assume that in a long bull market, a firm's beta happens to be say 1.25. Now suppose the market moves into a bearish phase. The quality of decisions taken by the management ensure that the results do not go down to the extent of other players and hence the market . The cost of equity for such a firm will be higher by virtue of a higher beta. This does not appear logical. What do you say ??

 

Regards,

Murugavel

 

 

----- Original Message -----
From: "Sivaprakasam p" <sivapra...@gmail.com>
To: "bim finance" <bim_f...@googlegroups.com>
Sent: Wednesday, 27 October, 2010 17:41:48 GMT +05:30 Chennai, Kolkata, Mumbai, New Delhi
Subject: Re: Negative Beta and cost of equity

Sir,

Its a nice thought. But I fear I cant understand the link between raising equity and cost of equity. The willingness (of an investor) to invest in a fund raising exercise may not be corelated with the expected rate of return.

There is a point though. Price discovery happens with performance and negative stock movement means that investors' expectation of returns is reducing. So over a period of time, a more negative beta would mean a reduction in expected rate of return. My opinion is, negative beta is a consequence of reducing enterprise value. Negative beta can not be an input to enterprise value. In this case, you are right Sir, beta is not true beta. But tends to alpha, since the figure is more company specific. But MRP itself is an approximation and broad based, probably, there is an assumption in CAPM that the performance of companies dont correlate negatively.

I read that in reality, we cant find a negative beta stock. Negative beta is applicable for liquidation companies.

A candid admittance is that I am too confused to think further. Have been deliberating on this for a long time. Further inputs appreciated.

Regards,
Sivaprakasam P
BIM 25

On Wed, Oct 27, 2010 at 12:56 PM, MURUGAVEL <murug...@bim.edu> wrote:

Dear Friends,

 

Recently I had an opportunity to discuss on Negative Beta and Cost of Equity with a friend with respect to a specific context.

 

Let us consider that we have a company A run by a bad management. The company has for the last few quarters been reporting bad results and its investors are dumping the shares in the market. During the same period the stock market has been booming - say the sensex increases from 8000 to 18000 etc. Suppose this firm wants to raise equity, what do you think will the cost of equity ? Can this situation be deemed as 'true' beta - and can the cost of equity for such a firm be below the risk free rate ?

 

My view:

To the best of my knowledge, this is not possible. Forget what people in New York or anywhere else say, I would not put in my money in such a company - when returns are below the risk free rate....This is not my idea of 'insurance' either.

 

What do you think ?

 

Regards,

Murugavel

 

 

 

 

--
You received this message because you are subscribed to the Google Groups "BIM_Finance" group.
To post to this group, send an email to BIM_F...@googlegroups.com.
To unsubscribe from this group, send email to BIM_Finance...@googlegroups.com.
For more options, visit this group at http://groups.google.com/group/BIM_Finance?hl=en-GB.

--
You received this message because you are subscribed to the Google Groups "BIM_Finance" group.
To post to this group, send an email to BIM_F...@googlegroups.com.
To unsubscribe from this group, send email to BIM_Finance...@googlegroups.com.
For more options, visit this group at http://groups.google.com/group/BIM_Finance?hl=en-GB.

[arun kumar]

Hi friends,

The entire CAPM is based on the assumption that there are two kinds of risks and the company risk is diversifiable if the asset is a part of a portfolio and the market risk is not diversifiable . Hence ur risk is only the market risk and u get paid for that. So beta in a layman's perspective is what I can expect in return for the market risk .

In the above example , the management doin bad is a company specific risk . The fact that the company stock price goes down while market moves up doesnt make it negative beta , because the reason for the decline is not market . If the market were to enter into bearish phase the stock would still decline and would give a positive beta then . So only if a company stock price decreases when the market increases and vice versa can we say that it has a negative beta .

Now assume that we really happen to find a stock which gives negative beta . If the markets are going up , u wouldnt buy it expecting returns because we know anyway it will go down . So the only reason why anyone will buy it is for insurance purposes where he may buy this negative beta stock along with a positive beta stock portfolio neutralizing the market risk in case of a macroeconomic disaster (i.e focussing on alpha return) . So intuitively , the negative beta stock is added to a portfolio as a insurance against losses . So the investors expectation of returns would be subdued which explains the expected return lower than the risk free rate .

My only problem is however while the market goes down , wont investors flock towards a negative beta stock expecting a higher return while the capm gives a sub-risk free rate . Eg investing in gold while the sensex tanks . Obviously I wont be expecting a less than Risk free rate for I would be much more comfortable investing in a bank deposit .

But one point to ponder about is that gold for the past 20 years has given around 6.3% returns annually which is lesser than the Risk free rate ..

Please do chip in with ur thoughts...

Please do

more about me @ http://coffee-with-life.blogspot.com/

[Abhishek Roy]

Hi All, 

         I think we are pondering to much into the negative aspect of beta rather then going into the essence of the what we mean by 'negative beta and cost of equity'

As per my understanding on a realistic note negative beta can be considered as a low beta stock/ company (say beta of 0.1), in such a situation the cost of equity of the company would be very low (applying the CAPM model), in other words when the overall risk of a stock or company is less , investors find it safer investment avenue ( remember risk is nothing but the volatility in returns). So the cost of equity of such companies with very low beta incidentally becomes low , though it might not be lower then the risk free rate in a real world scenario.

A parallel can be drawn from the fact that bigger corporates with strong financials were until sometime back able bargain for 'Sub BPLR' rates for their loans from Banks!

 

Regards

Roy

[Vikas Singh]

Dear Sir,

I will try to add upon Arun's Point...

Lets assume there is some insurance company which is offerring pure term life insurane and a person takes this insurance policy. If the person dies too early than his (actually dependent's) return on money invested in form of premium will be very high. Or if the person actually dies just before the maturity than the return is very very low. However, if one doesn't die within that time frame than return will be negative. Does that mean this insurance doesn't make sense? I hope you will agree on this point that it still makes sense (atleast to few) and the reason is that this is insurance and not real investment. Similarly, as stated by Arun, the investment in asstes having 'real' negative beta is also insurance (insurance from sudden fall of market) and not investment.

Only difference in negative beta assets as insurance and a pure term life insurace is that the insurane company has legal obligation to pay the sum assured where as in case of market assets there is no such arrangements. The return to the investors on such negative beta assets purely depends on the premises that, as the fundamentals of the assets are opposite to the market, the asset will perform very well when market will fall. That is when the other investors who have not invested in this asset till now will realize it's value and start giving much more premium than earlier. The initial investor can exit at this time and book very high profit (which will compensate his negative returns from market atleast partly). Thats what he wanted and thats why he had invested in this asset. Isn't this situation similar to the insurance case?

Another issue is that, the beta that we calculate using regression may not be always correct, because if that is not the case than why does it happen that beta calculated with different set of closing prices (for same stock) are different. However, just because we don't have a model to measure the 'real' beta it doesn't mean that the 'real' beta doesn't exist. If you can see that fundamentals of a sector are just opposite to the market than it will definately work as insurace and it's beta will also be negative.

Thanks & Regards,
Vikas Kumar Singh
+91-9344223111

[MURUGAVEL]

Hi Arun, Vikas and others,

 

Good. Beta measures the sensitivity of an investment's return  to fluctuations in overall market return.So, beta does not capture firm specific risk and only systematic risk is captured. (We will need to understand what this firm specific risk is also all about - does it include a firm's choice of an industry , its position in it etc ? )

 

My questions are

a) Ignoring all firm specific risks, what can be the reasons for a particular stock ( that forms a part of a market) to have a variance from the market ? ( for the sake of simplicity - we look at one particular asset class only in a portfolio)

 

b) Cost of equity calculation using CAPM does not seem to consider firm specific risk ... Coz, only beta changes from firm to firm - Rf, E( Rm) etc  remain the same. And we agreed that beta does not capture the firm specific risk. .... how good is that as a measure of Cost of Equity for a firm then ? 

[Vikas Singh]

Dear Sir,

 

As per our discussion, we agreed that we do not have a good model of calculating 'true' beta. But the CAPM model is still very much valid for calculaton of expected return or cost of equity of a firm (just that you need to provide 'true' beta) in absence of such measures we can either consider some other way to measure the cost of equity or stick to CAPM.

 

Also, one needs to understand the premise on which CAPM was proposed. The firm specific risks needs to be diversified by the investor and the market can give you return only for market specific risks. Extending that to calcuate cost of equity of a firm sometimes can be disastrous...but then the issue is not in CAPM but usage.

 

I would re-iterate the point that if at all it is possible that fundamentals of a particular sector/industry/firm are just opposite to the market then its 'true' beta will be negative and the cost of equity of such sector/industries/firm will be less than risk free rate during the period when market premium is positive (irrespective of whether you use CAPM or any other model)

Regrads,

Vikas Kumar Singh

+91-9344223111

[Sivaprakasam p]

Dear Sir,

Just like your disclaimer, following are just my understandings acquired by past learnings.

Historical beta is used as an approximation for predicting stock movement vis-a-vis market. On an average a stock tends to be evenly sensitive to market movements. The foundation of CAPM will be rocked only if beta is direction dependent. Beta is actually magnitude dependent. It actually doens't matter whether market is bearish or bullish. Correct me if I am wrong.

Regarding the valuation part, Sir, I feel when the FCFE starts becoming negative the stock price will tend to zero. Any future bad results will be factored in the present price. Or say lets assume, RIL declares a Q3 PAT which is half of Q2 PAT, and say RIL assures that Q4 PAT will be back on track, only then will the stock price hang on. Else the price will plummet and will factor in even further declining profits. In the second case, for further decline in PAT, the price will remain stable. Worse still the possibility of a positive shock is higher. Possibly the conclusion is the scenario which you are saying will happen only if the company is constanly cheating the investors so that continuous negative shock happens, which is a too ideal case.

Regards,
Sivaprakasam P
BIM 25

On Wed, Oct 27, 2010 at 7:00 PM, MURUGAVEL <murug...@bim.edu> wrote:

[vicky113 .]

I believe the way Vikas has tackled the question is the best  and simple solution I can think of, but I just want to give 1 more approach to this question.

Lets say we have a private firm (a book store), what is its cost of equity? What do you all think?

The conventional approaches of estimating betas from regressions do not work for assets that are not traded. There are no stock prices or historical returns that can be used to compute regression betas.

There are two ways in which betas can be estimated for non-traded assets
• Using comparable firms
• Using accounting earnings

I will only look at the comparable firms technique for simplicity. Now we will go to the markte and look at all book stores which are publicly traded. And lets say we get some 12 such firms. So we will take the median beta for all these firms, the median Debt/equity ratio, we will find the unlevered beta, we will take the median Cash/firm value and calculate the unlevered beta corrected for cash and let that be 1.02.
But for this book store the debt equity ratio we have is the book value debt equity ratio and the debt equity ratio we use to find cost of equity is always market debt equity ratio, so we will take the median market debt equity ratio for this firm and let that be 53.47% and using a tax rate of 40% we get a levered beta of 1.35.
using a Rf of 3.5% and Rm of 6% we get cost of equity as 11.6%

Beta measures the risk added on to a diversified portfolio. The owners of most private firms are not diversified. Therefore, using beta to arrive at a cost of equity for a private firm will not give correct values. So we have to adjust the beta to reflect total risk rather than market risk. This adjustment is a relatively simple one, since the R squared of the regression measures the proportion of the risk that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market

In this case the levered beta of the firm is 1.35 and the average R square of the comparable publicly traded firms be 21.58%, hence the correlation with the market will be 46.45%. Hence the adjusted Beta is 2.91 and hence the cost of equity is 20.94%

This is the reason why publicly traded firms has less cost of equity than private firms.

I believe this takes care of the company specific risk doubt.

[Sivaprakasam p]

Something interesting in this line. In CAPM, we have to apply modulus to beta. Those whom I have discussed this with say that it is for this modulus that the CAPM guy got a Nobel. That s one but a nice learning out of this is beta is not true beta. And worse still alpha is not true alpha!

[vicky113 .]

In the original CAPM equation there is nothing called a modulus Beta. Its just Beta. If there was modulus Beta the SML would start looking like a V shaped curve, but AFAIK its not the case

[Sivaprakasam p]

I am bad in SML, so Vikas if you can explain a little further I will try to rationalise

[vicky113 .]

Security market line (SML) is the graphical representation of the Capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta).
The Y-intercept (beta=0) of the SML is equal to the risk-free interest rate. The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time.

Hence when you plot the SML its a upward looking straight line, meaning expected return increases with increase in Beta. Now if we take Beta as modulus Beta then as soon as beta becomes negative the expected return will be higher than the risk free rate which will make the curve as V shaped. Have you ever seen in any finance book or any where a V shaped looking SML? I dont recall reading in any book or any where that the SML can be V shaped.

[Vikas Singh]

Dear Sir,

 

First let me clarify something...

The person you were refering to in your last mail is not Vikas. His name is Debdipto Majumdar (email id - vick...@sify.com)...

 

Now coming to the point...

If modulus of beta is used in CAPM than I have a doubt...

I accept that regression beta is not true beta and it captures the "perceived" company specfic risk along with market risk. Having said that, lets assume a firms beta for a particular period comes out to be negative, say "- 0.3", using modulus the beta will be 0.3 which signifies that the company is relativley very less affected by market movements and hence should be perceived as less risky than market itself...

do you agree that...if a company's regression beta is negative it should be treated as less risky? (also, if beta is negative and large, say -2.5, than still isn't it way too risky to invest and the true beta should be much higher than 2.5)

 

I feel that if a company's regression beta is negative (without any fundamental issues) than it must be because of some bad reasons...like bad management, huge raw material or other procurement issue, serious and permanent labour issues etc...and in these conditions the investor should penalise the firm much more harshly than the market...I would say that true beta in that case should be somewhere around 2 to 3... the regression beta is negative because the bad inormations have already been factored into prices...(therefore even though the market was going up the price for this particular company went down).

 

Also, as the information have been factored into already, later if company actually does well than the share prices will shoot up much faster and the investors will make much more profit (justification for higher true beta).

please correct me, if my logic seems to be faulty...

 

Vikas Kumar Singh

+91-9344223111

[Sivaprakasam p]

@Debdito,

Please refer http://www.duke.edu/~charvey/Classes/ba350_1997/capm/capm.htm
Beta is the ratio of the covariance to the variance. I believe this can be negative mathematically. So you may be right. I will confirm this if possible.

But SML is usually drawn for positive beta. Please let me know if you come across a SML for negative beta.  Thanks.

@Vikas,
No idea, will have to confirm the modulus stuff.

[vicky113 .]

here u go dude http://www.edinformatics.com/investor_education/capital_asset_pricing_model.htm
it shows expected return at 0, which corresponds to negative beta. I think u get the point why normally they show a SML which starts from Rf??

[Sathyamurthy U]

Hi All,

I was wondering why we have so much of a fixation to models like CAPM. When we know that speculation plays a major role in the market then these models become flawed.  Should we be more abstract in our entire discussion instead of instructing what to think.  We can develop our own models and use this forum to get other people's views.  Being abstract helps us form infinite number of interpretations and hence infinite ideas.  

Regards,

Sathyamurthy

9884685857