Measuring Systematic Risk
Firms face additional risks besides credit and bankruptcy risk. Recessions, inflation, changes in interest rates, foreign currency fluctuations, rising unemployment, and similar economic factors affect all firms, but in varying degrees depending on the nature of their operation. The investor in a firm’s common stock must consider these dimensions of risk when making investment decisions. Differences in expected rates of return between investment alternatives should relate to differences in such risk. In this section, we briefly discuss how equity markets are used to obtain a broader measure of risk. Then we briefly relate this market measure of risk to financial statement information.
Studies of market rates of return have traditionally used the CAPM (capital asset pricing model). The research typically regresses the rate of returns on a particular firm’s common shares [dividends plus (minus) capital gains (losses)/beginning-of-period share price] over some period of time on the excess of the returns of all common stocks over the risk-free rate. The regression takes the following form:
Firms face additional risks besides credit and bankruptcy risk. Recessions, inflation, changes in interest rates, foreign currency fluctuations, rising unemployment, and similar economic factors affect all firms, but in varying degrees depending on the nature of their operation. The investor in a firm’s common stock must consider these dimensions of risk when making investment decisions. Differences in expected rates of return between investment alternatives should relate to differences in such risk. In this section, we briefly discuss how equity markets are used to obtain a broader measure of risk. Then we briefly relate this market measure of risk to financial statement information.
Studies of market rates of return have traditionally used the CAPM (capital asset pricing model). The research typically regresses the rate of returns on a particular firm’s common shares [dividends plus (minus) capital gains (losses)/beginning-of-period share price] over some period of time on the excess of the returns of all common stocks over the risk-free rate. The regression takes the following form:
The beta coefficient measures the covariability of a firm’s returns with the returns of a diversified portfolio of all shares traded on the market (in excess of the risk-free interest rate). Firms with a market beta of 1.0 experience covariability of returns equal to the average covariability of the stock market as a whole. Firms with a beta greater than 1.0 experience greater covariability than the average. Firms with a beta less than 1.0 experience less covariability than the average firm. For example, a beta of 1.20 suggests 20% greater covariability; a beta of 0.80 suggests 20% less covariability. Beta is a measure of the systematic (or undiversifiable) risk of the firm. The market, through the pricing of a firm’s shares, rewards shareholders for bearing systematic risk. Elements of risk that are not systematic are referred to as unsystematic risk. Unsystematic risk factors include diversifiable firm-specific risks such as specific product obsolescence; labor strikes; loss of a lawsuit; and damages from fire, weather, or natural disaster. By constructing a diversified portfolio of securities, the investor can eliminate the effects of unsystematic risk on the returns to the portfolio as a whole. Thus, market pricing shouldprovide no returns for the assumption of nonsystematic risk.
Several firm-specific factors are intuitively related to a firm’s market beta, including:
Several firm-specific factors are intuitively related to a firm’s market beta, including:
- Operating leverage
- Financial leverage
- Variability of sales
Each of these factors causes the earnings of a particular firm to vary over time, and due to the association between earnings and stock prices, these factors are associated with a firm’s market beta. Operating leverage refers to the extent of fixed operating costs in the cost structure. Costs such as depreciation and amortization do not vary with the level of sales. Other costs, such as insurance and executive and administrative salaries and benefits, may vary somewhat with the level of sales, but they remain relatively fixed for any particular period. The presence of fixed operating costs leads to variations in operating earnings that are greater than contemporaneous variations in sales. Likewise, financial leverage (discussed earlier in the chapter) adds a fixed cost for interest and creates the potential for earnings to vary at a greater rate than sales vary. Thus, both operating and financial leverage create variations in earnings when sales vary but firms cannot simultaneously alter the level of fixed costs.
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