Beta Estimation

Submitted By karan123
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Calculating and Interpreting Beta
Introduction:
In 1990, William Sharpe won a Nobel Prize in Economics for his work in developing the Capital Asset Pricing Model (CAPM). Traditionally the CAPM has been the basis for calculating the required return to the shareholder. This figure in turn has been used to calculate the economic value of the stock and the
Weighted Average Cost of Capital (WACC) for capital budgeting. In recent years, the CAPM has been attacked as an incomplete model for explaining market pricing behavior, but academics and practitioners cannot agree on a good replacement. And so the CAPM remains an important model in practical investment and financial management decision making.
Calculating Beta:
The most important component in calculating the required return to shareholder (from the CAPM) is the company’s beta. The CAPM can be succinctly stated as: k s  k RF  k M  k RF  s  k RF  Market Risk Premium  s
[1]
The original model was conceived of theoretically, and was expected to be forward looking. Careful reading of Sharpe’s original work show that the market assesses systematic risk looking at expected future covariance of the company’s returns with that of the overall market. It is assumed that these covariances are unbiased and efficient estimates of the observed relationships ex post facto.
Traditionally the CAPM relationship is estimated using simple regression on historical outcomes, where ks is the y variable, and kM-kRF (or the market risk premium) is the only x variable. Care must be taken that the returns plugged into the regression are all for the same period. Calculated stock returns should be annualized if the risk-free rate is an annual rate.
The market risk premium is merely the difference between the return to the market portfolio and the risk-free rate. Academics typically use a value
weighted...

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