Does beta value change everyday? Time-Varying of Beta
The most fundamental concepts of modern portfolio theory are alpha and beta. We usually refer to the beta correlation between a single stock and the broader stock market. For example
r(Amazon) = Rf + beta*(Rm-Rf) + alpha
In this formula, beta can refer to either the historical beta (historical beta) or the predicted beta (predicting beta) for a period of time in the future. For example, we say that Amazon’s beta is 0.9, which has two meanings. When referring to historical beta, it means that over the past period, the correlation between Amazon stock and the broader market was 0.9. Specifically, the broader market is up 10% over the past year, and Amazon is up 9%.
When we refer to forecasts for a while in the future, we are saying that in a period in the future, such as the next year, the correlation between Amazon’s performance and the performance of the broader market is 0.9, that is, if the market goes up by 10%, then we forecast Amazon to rise 9%.
The betas we usually talk about are historical betas, while the betas in risk models such as Barra are predictive betas.
If the relationship between Amazon and the broader market is considered to be as stable in the future as it has been in the past, the two betas are similar. However, if there is a unique view of the e-commerce industry or California’s economy, it is clear that the predicted beta and the historic beta will be different. Given the same length of back-test, all market participants will get the same historical beta (this is real), and each will have a different beta for the prediction.
One of the assumptions we make in applying the market model to estimate beta is that beta does not change over time.
Because, according to the financial formula, Beta becomes determined by the expected return of the market portfolio and the expected return of the asset. However, we all know that theoretical assumptions are often difficult to achieve in reality. Macroeconomic factors and market investors’ preferences all lead to changes in the systemic risk of assets in different periods. In other words, Beta is changing over time. I will explain the time variability of beta from the following five aspects.
1. The most obvious and straightforward reason is that a single stock is part of the broader market.
For example, when Amazon is up 9%, the stock market as a whole must be up (because one part of the stock market, Amazon, is up). So it’s a truth by definition that Amazon’s rise drives the stock market higher. In this sense, changes in individual stocks lead to changes in the broader market.
2. From the perspective of the company, when individual stocks rise or fall, it often means that the company’s financial situation has changed.
Companies are all upstream and downstream industries, with suppliers and consumers. When the financial situation of the company changes, it will affect the affiliated enterprises. Therefore, changes in individual stocks lead to changes in affiliates, which in turn lead to changes in the broader market.
3. Next, from the perspective of the stock market. When interest rates change, the stock market discounts future dividends according to the current interest rate environment.
The lower the interest rate, the higher the valuation. Therefore, changes in macro interest rates will lead to changes in the valuation of all companies. At this level, all listed companies are affected by the same macro factor (interest rate) and change together.
4. Similarly, from a macroeconomic perspective, when the economic situation deteriorates, the overall earnings expectations of all companies or a certain industry deteriorate as well.
Which in turn causes the valuation of each stock to fall. Therefore, this change is transmitted from the macro economy to the broader market and then to individual stocks.
5. Finally, there are many structured investors in the market who hold a large number of index-linked passive investments.
For example, in the Chinese market, when these investors increase or decrease their holdings of these indexes, such as when foreign capital enters the Beijing market through Shanghai and Hong Kong, they will buy all the stocks in the index. This is a capital flow that causes some stocks to change together.
In conclusion, the correlation between individual stocks and the broader market is due to (but not limited to) the reasons mentioned above:
Either economic, individual stocks have led to changes in the upstream and downstream of the industrial chain; either macro shocks or capital flows have led to the broader market driving stock changes.
So what is the investment guiding significance of beta? The simplest is to distinguish the interest rate beta. Or the earnings beta caused by the worsening of the overall economic profit expectations. If the stock price rises due to falling interest rates and earnings expectations do not improve. As a result, then this beta is generally considered a bad beta. To make things a little more complicated. The forecast for beta for a period of time in the future can be adjusted based on research on industries and individual stocks. Risk managers can also further subdivide different betas. For example, many risk models are divided into “local market beta” and “global market beta” and so on.
Of course, with the development of modern portfolio theory, people have created countless factors, such as value, momentum, reversal, etc. However, a factor model, no matter how complex, starts with analyzing beta.
