The Beta Coefficient

The Beta Coefficient

Question 1a

The Beta Coefficient measures the likelihood of stock prices to change based on the market price. It also determines regular risks linked to an investment. Based on the CAPM model, the beta coefficient shows the variations in a dependent variable from 1 unit adjustment of the independent variable; hence, comparing the change effect of predictor variables to the dependent variable. Therefore, a larger absolute value of this coefficient shows that its impact might be stronger. The coefficients are computed according to a market index. The formula for beta is given as follows:

A beta coefficient of 1 indicates that the stock price is moving at the same rate as the market price. If the coefficient is less than 1, the return of a stock is less likely to change based on market deviations; however, if the beta is more than 1, the stock returns are more likely to move by the market’s price fluctuations. Table 1 presents a summary of beta coefficients for JD Sports Fashion PLC, Tesco PLC, and Burberry Group PLC, computed according to the FTSE100 index. The beta coefficient for JD Sports Fashion PLC is 0.11, indicating that the volatility of the stock is quite low and 89% less likely to follow the market deviations. Tesco has a beta of 0.22, which shows that its stock is 78% less likely to shift due to changes in the market. Lastly, Burberry’s beta coefficient is 0.37, indicating that the likelihood of the stock to respond to the market conditions is 63% unlikely. Considering the CAPM model, the stocks for Burberry are riskier, followed by Tesco’s, and lastly JD Sport’s; however, since all the beta coefficients are below 1, there is a likelihood of low returns and less associated risks.

JD Sport

Tesco

Burberry

Beta Coefficient

0.113238728

0.223410572

0.373369844

Table 1: Beta Coefficient

Question 1b

Roll’s critique analyzes reliability and validity of results from empirical tests on CAPM Models, which links the expected return of an asset to its correlation and the market return. The major assumptions made by this critique include: (a) the mean-variance efficiency of a market portfolio is equal to CAPM Model’s equation, and (b) there is a market portfolio that cannot be observed. Based on the first assumption, testing the average-variance of the portfolio’s efficiency is equated to evaluating the CAPM Model equation. If the market is presumed to have mean-variance efficiency, then the CAPM Model can be repetitive according to availability of investment opportunities. The second assumption implies that the market portfolio might include all the available assets, but the returns on possible investments cannot be observed. Furthermore, the inefficiency market proxies can be explored by the concept of relative efficiency, which is tested by pricing restrictions that reflect proxies returns associated to market returns, and specific stock returns linked to the proxy. Relative efficiency of market proxies is measured by correlating the return of a proxy and that of the market. Based on this efficiency, the errors of CAPM pricing can be determined in relation to the proxy. It is considered to be CAPM’s conditional test, taking into account the efficiency of the proxy. If a proxy is far from the boundary of the mean-variance, the market return is likely to be less efficient. Moreover, a proxy that is not efficient in terms of mean-variance results in invalid CAPM, which affects predictions based on the model. The pricing restriction is critical when determining the validity of CAPM conditional relationship between the proxy returns and the market returns. Therefore, the inefficiency of market proxies is a significant drawback of the Capital Asset Pricing Model (CAPM).

Question 2a

The momentum strategy is a technique in an investment where the winners are bought, and the losers are sold. Table 2 shows the constituents of the winner portfolio, and Table 3 presents the loser portfolio from the returns in August. ANTO LN Equity has the highest performance, followed by BDEV LN, SBRY, MRW LN, and DCC LN as the top five stocks. On the other hand, ADM LN has the lowest return followed by STAN LN, OML LN, IAG LN, and PRU LN as the bottom five stocks.

Winner Portfolio

ANTO LN Equity

9.274%

BDEV LN Equity

3.149%

SBRY LN Equity

2.975%

MRW LN Equity

2.098%

DCC LN Equity

1.834%

Table 2: Winner Portfolio

Loser Portfolio

PRU LN Equity

-4.155%

IAG LN Equity

-4.503%

OML LN Equity

-4.739%

STAN LN Equity

-4.932%

ADM LN Equity

-6.096%

Table 3: Loser Portfolio

Assuming that there is no cost of transaction, the return at the end of September is determined by the difference between the returns in the winner and loser portfolios. Table 4 shows the returns of the strategy. The momentum strategy yields a range of returns from 7.03% to 13.43% by the end of September. Based on this summary, the strategies result in significant returns, indicating that there is profitability. It can be suggested that there is a momentum effect because the assets follow an upward trend due to the positive values resulting from the difference in the two portfolios. As much as the effect of momentum is positive, investors might not take advantage because the influence of transaction costs is not considered in the strategy. The costs of a transaction might include commissions of trade and cost of borrowing, which might be challenging to determine due to fluctuations in market prices and conditions set by financial institutions. In general, there is a significant momentum effect that shows an upward trend in market returns.

Winner

9.274%

3.149%

2.975%

2.098%

1.834%

Loser

-4.155%

-4.503%

-4.739%

-4.932%

-6.096%

Winner-Loser

13.428%

7.652%

7.714%

7.029%

7.930%

Table 4: Momentum Effect

Question 2b

The efficiency of a market is the level at which prices reflect all the information available for investors. Reliable information in the market affects prices because it is incorporated at every slight change; thus, the value of stocks and securities cannot be overestimated or underestimated. The EMH can be described as an investment hypothesis where the stock prices reflect all the information that is consistent with market trends. It claims that the stocks are usually traded at a relatively fair value, which makes it difficult for investors to buy overpriced or underpriced assets. As such, it can be challenging to beat the market using a smart asset selection, or through market timing; therefore, investors might only earn higher returns if the investment has many risks. The momentum effect raises or lowers stock prices. In circumstances where the assets are underpriced or overpriced by the momentum effect, investors might fail to buy the stocks due to market inefficiency. However, when the market is efficient, there is relevant information that can eliminate any possibility of outperforming the market. Additionally, an efficient market informs traders any eventualities of changes in prices. Generally, the market can become inefficient when the quality of information reduces, increasing opportunities for simultaneous selling and purchasing of assets below the market returns.

EMH suggests that investors might perform better when purchasing assets that are lowly priced because of the market’s randomness. It also assumes that there is rationality in the market and prices are a reflection of the available information. The momentum effect might be a source of anomalies in an efficient market because most investors take timely actions when the stock prices are adjusted to reflect the available information. So, there is no investor with the ability to outperform the market by earning abnormal returns. A market that uses momentum effect is full of anomalies because it does not follow the EMH rules. The irregularity caused by the momentum effect is inconsistent with the standard Capital Asset Pricing Model (CAPM) because it places weights new improvements over the required investment limits. Besides, the variances brought about by the momentum effect might disappear and leave the market unpredictable. Therefore, the momentum effect cannot be compatible with the efficient market hypothesis because of inconsistencies with the asset pricing models.