- This topic has 10 replies, 3 voices, and was last updated 2 years ago by
.
- Posts
Hi,
I would like to understand if the systematic risk is equivalent to the ungeared beta which is general for companies in a particular sector. When debt comes into the picture, every company will have a different geared beta and as I understand it, geared beta includes the systematic risk (ungeared) plus the debt component for a company.
Is this correct?
Systematic risk refers to risk that can’t be diversified away. Beta refers to extent to which it is likely that a company will move with the market in question. The ability to recognise which sector beta applies to financial decision and the ability to take out impact of debt on beta are important skills to master but different from what composes systematic risk. Hope this helps.
Thanks for the explanation. I understand that systematic risk is the risk that can’t be diversified away and is equivalent to beta.
Suppose that A is in a sector where asset / ungeared beta is 1.5. A has gearing and thus equity / geared beta is 1.8, an additional 0.3 beta. This is actually company-specific as other companies might have other levels of gearing or not at all. Assume that I buy all the shares of the companies in this particular sector, couldn’t I in theory be diversified enough that the 0.3 additional beta be neglible? Of course, it could be that other companies are geared in the same level or higher and thus the 0.3 could be even higher.
I understand that the definition of systematic risk composes geared and ungeared. Business risk / ungeared cannot be eliminated but the geared beta (debt portion) is debatable in my opinion. It’s not going to affect the exams but I’m just trying to understand this portion.
This forum is for students to help each other, but I will give you an answer (even though I usually only answer in the Ask the Tutor Forum).
Gearing creates extra risk but it cannot be measured separately, in the sense that you cannot say that the gearing risk is simply an extra 0.3 added on to the beta. What gearing does is increase the equity beta by multiplying the asset beta (as per the asset beta formula).
As you write, it is all systematic risk and it cannot therefore be diversified away. The total systematic risk (the equity beta) of a portfolio of shares will be weighted average of the individual equity betas (as explained in my free lectures) and depends on both the pure business risk and the level of gearing in each of the individual shares.
Thanks for the explanation John.
Suppose I invest in 10 companies with lower gearing, thereby with lower equity beta and lower total systematic risk rather than investing in 10 companies with higher gearing. In this sense, I am reducing my total systematic risk (lower weighted average equity beta) even though I am investing within the same sector with same asset beta. Can this be seen as diversifying away some of the systematic risk (even though theoretically systematic risk cannot be diversified).
In exam terms and in real world terms, a lot of this involves de-gearing and then re-gearing in order to ultimately get appropriate cost of finance for a given project. It’s simpler than it sounds but harder to explain without a question. Beta is probably best thought of as a measure of volatility for a sector. Excluding debt component is useful in this context to get purer idea of risk. It is similar to reason why return on capital employed is generally better metric of comparison between companies than return on equity because a highly geared company will show better return on equity purely based on its decision to debt finance it’s operations. Particularly in decisions involving acquisitions, return on capital employed is a better measure as ultimately if you take over control of company then you will determine the level of debt to equity with which you wish to finance the operation. Sorry for long explanation. Hope it is of some help.
Ultimately investing in low beta companies would reduce volatility of investment but would not eliminate systemic risk.
You would need a negative beta to hedge against systemic risk. In reality these would be rare if they exist at all as businesses tend to prosper as the economy prospers and decline as the economy declines.
mrjonbain wrote:In exam terms and in real world terms, a lot of this involves de-gearing and then re-gearing in order to ultimately get appropriate cost of finance for a given project. It’s simpler than it sounds but harder to explain without a question. Beta is probably best thought of as a measure of volatility for a sector. Excluding debt component is useful in this context to get purer idea of risk. It is similar to reason why return on capital employed is generally better metric of comparison between companies than return on equity because a highly geared company will show better return on equity purely based on its decision to debt finance it’s operations. Particularly in decisions involving acquisitions, return on capital employed is a better measure as ultimately if you take over control of company then you will determine the level of debt to equity with which you wish to finance the operation. Sorry for long explanation. Hope it is of some help.
Thanks a lot for the explanation. It makes more senes when brought into the real world context.
For my better understanding, is the sector beta calculated by the average movement of the sector vs the market as a whole? I assume this is considered the asset / ungeared beta for the sector regardless of the various levels of gearing of the companies within the sector. Some companies within the sector could be higher and some even lower than the sector beta? Or did I misunderstood how the sector beta is calculated?
In terms of calculating beta, in practice I think statistical techniques are used to compare a company’s historical return with the return of a valid index. This could be something like the one of the FTSE indexes.This is easier if it is a well traded public company. The following is a good source for how adjustments for gearing are carried out and for selecting relevant Beta-
Hope this helps.
An important point is to try to find a relevant business or sector with which to find a beta. For example, if a company were to want to develop a supersonic airline, using the beta of easyJet or even average of general airline groups would not be as appropriate. On based on luxury airlines would be more appropriate.
- You must be logged in to reply to this topic.