Limitations of using Beta as a standard measure to assess risks

Résumé du document

Risk reduction is needed to obtain security on expected returns. On the one hand some risks can be diversified, like unsystematic risk, and on the other hand systematic risk can not be diversified because they are inherent in the company's activity. There is only one exception, systematic risk can be diversified by investing in other markets. To reduce systematic risks which are market risks, there are tools like Beta available. Beta is a coefficient used to calculate the Security Market Line and the Capital Asset Pricing Model. Market risk refers to a risk which depends on movement of interest rate, foreign exchange rates, and prices of instrument in money. It is a risk when these systematic factors have a negative effect on the earnings and the financial institution's capital. Beta measurement assesses the sensitivity of individual security returns to systematic factors on the overall market portfolio. Thus this tool indicates how sensitive a portfolio is, to market movements.

Extraits

[...] Their flaws show to us limitation of using Beta to assess risk. On the one hand it's useful to remember briefly how Beta is used to assess risk. And on the other hand it's relevant to extract from this concept different nature of limitation. To define limitation of using Beta, it's necessary to remember how beta is used. To calculate Beta we have to divide covariance of asset by variance of the market. But almost investors obtain Beta thanks to Risk Management Service, like London Business School service. [...]

[...] To conclude, Beta has two essential characteristics. It measures the risk added on a portfolio which is diversified. It's a relative measure of risk and a relative measure of systematic risk. If investors want to find the best use of the beta coefficient, they have to use it for short term investments. Because in short term investments price volatility is important. So use Beta if you are planning to buy and sell investments in a short period. Nevertheless, this indicator has too many defaults to be used like a predictor of risk for a long term investment. [...]

[...] Nevertheless this assessment of risk is relevant but not perfect. First of all, there are some problems using only beta result to determine risk of an investment. Beta just assesses systematic risk. In fact, Beta assumes that unsystematic risks are diversified away. So Investors have to diversify the other risks, thanks to the Markovitz's portfolio theory. Furthermore, there is more limitation of using Beta to assess risk. We could attack how this coefficient is calculated. In practise, there are two measurement problems which can affect Beta. [...]

[...] Limitations of using Beta as a standard measure to assess risks The reason for the risk reduction is to obtain a security on expected returns. On the one hand some risks can be diversified away, like unsystematic risk, and on the other hand systematic risk can not be diversified because they are inherent in the company's activity. There is only one exception, systematic risk can be diversified by investing in other markets. Nevertheless to reduce systematic risks which are market risk, there are some tools like Beta. [...]

[...] But there is also limitation to assess risk. In practice it's very relative to estimate forecast return and the associated probabilities of each possible return. Because of these reasons Beta can vary widely. This coefficient depends a lot on what data sources are used, and what measurement period is chosen. We can take an example delivered by Babson College, about the assessment of Goldman Sachs's Beta, in 2004. We obtained a range of results between 1.03 and 1.36 according to use different data, different measurement period. [...]