Thus another occasional choice would be the use of international indexes, such as the MSCI EAFE. stock market is too narrow, omitting all sorts of other domestic and international asset classes. Practitioners tend to prefer to work with the S&P500 due to its easy in-time availability and availability to hedge with stock index futures.Ī reasonable argument can be made that the U.S. In practice, the choice of index makes relatively little difference in the market betas of individual assets, because broad value-weighted market indexes tend to move closely together.Īcademics tend to prefer to work with a value-weighted market portfolio due to its attractive aggregation properties and its close link with the CAPM. ( December 2020) ( Learn how and when to remove this template message) Statements consisting only of original research should be removed. Please improve it by verifying the claims made and adding inline citations.
This section possibly contains original research. R i, t = α i + β i ⋅ r m, t + ε t, Choice of market portfolio and risk-free rate The market beta of an asset i is defined by (and best obtained via) a linear regression of the rate of return of asset i on the rate of return on the (typically value-weighted) stock-market index: Technical aspects Mathematical definition It does not measure the risk when an investment is held on a stand-alone basis. Thus insured, movements of the overall stock market no longer influence the combined position on average.īeta thus measures the contribution of an individual investment to the risk of the market portfolio that was not reduced by diversification. For example, to hedge out the market-risk of a stock with a market beta of 2.0, an investor would short $2,000 in the stock market for every $1,000 invested in the stock. Treasury bills (like most fixed income instruments) and commodities tend to have low or zero betas, call options tend to have high betas (even compared to the underlying stock), and put options and short positions and some inverse ETFs tend to have negative betas.īeta is the hedge ratio of an investment with respect to the stock market.
In practice, few stocks have negative betas (tending to go up when the market goes down). If an asset has a beta above (below) 1, it indicates that its return moves more (less) than 1-to-1 with the return of the market-portfolio, on average. 6 Equilibrium use: fair reward for risk?īy definition, the value-weighted average of all market-betas of all investable assets with respect to the value-weighted market index is 1.4 Choice of market portfolio and risk-free rate.3.3 Adding an asset to the market portfolio.3.2 Relationship between own risk and beta risk.
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