A turning point in the debate on risk and return occurred in the early 1990s, when Gene Fama and Ken French wrote one of the most-quoted and influential papers on the topic. In it, they began with a simple premise. If our objective in risk and return models is to come up with expected returns on investments, should we not judge the quality of these models by looking at how well they explained actual returns over very long time periods? They began by looking at the CAPM: in it, all return differences across investments should be explained by differences in betas. Looking at actual stock returns...
Can betas be negative? (and other well used interview questions)
Here is a favorite question among corporate finance interviewers: " Can betas be negative? And if so, what exactly do they tell us?" The reason negative betas pose a conundrum to many finance students is that they seem to go against intuition. After all, if a beta of one is average risk and a beta of zero is riskless, how can an investment have negative risk?Here is the answer. Yes, betas can be negative. To see how and why, consider what betas measure: the risk added by an investment to a well diversified portfoli0. By that definition, any investment that when added to a portfolio, makes the...
Alternatives to Regression Betas
In my prior post, I explain why I am averse to regression betas - the high standard errors of the estimates, the backward-looking nature of the estimates and the loss of intuitive feel for risk. In this post, I would like to look at alternatives that are offered to regression betas, with an eye towards making better estimates:1. Relative standard deviations: The beta is a function of the standard deviation of the stock, the standard deviation of the market and the correlation of the stock with the market:Beta = (Correlation between stock and market) (Std dev of stock)/Std dev of mktThe primary...
The problem with regression betas
I must confess that I find the practices used to estimate betas to be both sloppy and counter intuitive. The standard approach, offered in every finance text book, is to regress returns on the stock against returns on a market index, with the slope yielding the beta. I have five problems with this approach:1. Statistically, the slope coefficient in a simple regression comes with a standard error. The beta estimate for a typical US company has a standard error that is about 0.20. One way to read this number, is when you are told that the beta for a company (from a regression) is 1.10, the true...
What betas can... and cannot do...
There is no concept that is more abused, and more misinterpreted, than beta in corporate finance. I have heard betas blamed for everything from global warming to the market collapse. "Warren Buffet does not use beta", the refrain goes, "so why should I?"I think the biggest mistake that people make is to wrap betas up with the assumptions of the capital asset pricing model (CAPM). Does the CAPM make unrealistic assumptions about no transactions costs and no private information to get to its final conclusion (that all exposure to market risk can be captured in a beta, which should then be the sole...
Executive Compensation Caps
The news of the day is the decision by the Obama administration to put caps on executive pay, at least at the companies that have lined up to received funds from the government. Not surprisingly, there are people with strong views lining up on both sides of the issue. So, I guess I will stick my toe into the water and hope not to get burned (since there is an obvious political component to this debate).As a general rule, I don't think governments should have any role to play in setting compensation limits. The heavy hand of government intervention will not only create quirks in the labor market...
Low riskfree rates...
One of the many perils of valuing a company in the US or Europe right now is that the riskfree rates in US dollars and Euros are at unprecedented lows - about 2.3% in US $ and about 2.8% in Euros. Analysts, confronted with these riskfree rates, are faced with a quandary. If they use the low riskfree rates, they end up with low discount rates which then result in high valuations. To get around this problem, many are asking the question: Are riskfree rates too low and should we replace them with higher normalized rates (perhaps average rates over time)? Good question, but the wrong place to ask...
