Risk is an important consideration in holding any portfolio. The risk in holding

securities is generally associated with the possibility that realised returns will be less

than the returns expected.

Risks can be classified as Systematic risks and Unsystematic risks.

Unsystematic risks:

These are risks that are unique to a firm or industry. Factors such as management

capability, consumer preferences etc. contribute to unsystematic risks. Unsystematic

risks are controllable by nature and can be considerably reduced by sufficiently

diversifying one's portfolio.

Systematic risks:

These are risks associated with the economic, political, sociological and other

macro-level changes.They affect the entire market as a whole and cannot be

controlled or eliminated merely by diversifying one's portfolio.

Is a measure of the volatility, or systematic risk, of a security or a portfolio in

comparison to the market as a whole.

In simple lehman terms:

Beta can be thought of as a “tendency of a security’s returns to respond to the

swings/changes in the market”.

Is used in capital asset pricing model (CAPM), a model that calculates the expected

return of an asset based on its beta and expected market returns.

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*Volatility

Volatiliity means risk.

A model that describes the relationship between risk and expected

return and that is used in the pricing of risky securities.

It says that the expected return of a security or a portfolio equals the rate

on a risk-free security plus a risk premium.

The general idea behind CAPM is that investors need to be compensated

in two ways: time value of money and risk.

Formula:

•Covariance

A measure of the degree to which returns on two risky assets move in

tandem. A positive covariance means that asset returns move together. A

negative covariance means returns move inversely.

•Variance

Variance measures the variability (volatility) from an average. Volatility is a

measure of risk, so this statistic can help determine the risk an investor might

take on when purchasing a specific security.

A company of Beta:

1 will rise by 10% if the market rises by 10%

2 will rise by 20% if the market rises by 10%

-2 will fall by 20% if the market rises by 10%

0.5 will rise by 5% if the market rises by 10%

The volatility of the market is taken as 1 while calculating and the beta of stock is

calculated as how much the stock price moved in comparison to this market

volatility.

Negative beta: The price of the stock moves in reverse direction to the market

movement. Though this is a rare condition

Zero beta: The price of stock stays same over time irrespective of market

movement. This can sometimes happen in sideways moving markets, where no

major economic/industry/company news is coming up.

Beta less than one: The stock price moves less in comparison of market. Many

blue-chip and large-cap company stocks have beta value less than one, which make

them qualify for low-risk investments. But these stocks tend to offer low-returns

Beta of one: The stock price movement is same as that of market.

Beta greater than one: The stock price movement surpass market movement.

Many fast growing, mid and small-cap company stocks have beta higher than one.

These stocks tend to offer better return for high-risk taken.

Hamada’s equation, is used to separate the financial risk of a levered firm from its

business risk.

It is used to help determine the levered beta and, through this, the optimal capital

structure of firms.

Hamada’s equation relates the beta of a levered firm (a firm financed by both debt

and equity) to that of its unlevered (i.e., a firm which has no debt).

It has proved useful in several areas of finance, including capital structuring,

portfolio management and risk management.

Also used to determine the cost of capital of a levered firm based on the cost of

capital of comparable firms. Here, the comparable firms would be the ones having

similar business risk and, thus, similar unlevered betas as the firm of interest.

A type of metric that compares the risk of an unlevered company to the risk of the

market. The unlevered beta is the beta of a company without any debt. Unlevering

a beta removes the financial effects from leverage.

Where:

BL is the firm's beta with leverage.

Tc is the corporate tax rate.

D/E is the company's debt/equity ratio

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*Leverage:

The amount of debt used to finance a firm's assets. A firm with significantly more debt

than equity is considered to be highly leveraged.

As a company takes more debt its interest expense will rise Earnings will be more

volatile and hence the beta will increase to adjust fro increase in volatility.

Thus in this case beta levered is used to calculate risk associated with the same.

It is possible only to find out beta of a listed company.

But if we are trying to calculate the WACC for a business that is unlisted,then we

need to do the below mentioned:

a)Find out the comparable listed companies

b)Unlever their levered beta using the existing capital structure

c)Re-lever the beta using the target capital structure of the company you are trying

to vaue

It is a measure of how much systematic risk a firm's equity has when compared to

the market.

Unlevering the beta removes any beneficial effects gained by adding debt to the

firm's capital structure.

Comparing companies' unlevered betas gives an investor a better idea of how

much risk they will be taking on when purchasing a firms' stock.