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One of the challenges of using beta as a measure of risk is that it is not a static value. Beta can change over time due to various factors, such as market conditions, company performance, industry trends, and investor sentiment. Therefore, it is important to update beta periodically to reflect the current reality and avoid relying on outdated or inaccurate estimates. In this section, we will discuss how to update beta over time, the frequency and methods of beta recalibration, and how to incorporate new information into the beta calculation.
Here are some steps to follow when updating beta over time:
1. Determine the appropriate frequency of beta recalibration. There is no definitive answer to how often beta should be updated, as it depends on the nature and volatility of the asset, the availability and quality of data, and the purpose and scope of the analysis. Some general guidelines are:
- For long-term investors, beta can be updated annually or semi-annually, as they are more interested in the long-term trends and risks of the asset.
- For short-term traders, beta can be updated quarterly or monthly, as they are more sensitive to the short-term fluctuations and opportunities of the asset.
- For dynamic and fast-changing industries, such as technology or biotechnology, beta can be updated more frequently, as the market and competitive environment can change rapidly and significantly.
- For stable and mature industries, such as utilities or consumer staples, beta can be updated less frequently, as the market and competitive environment are more predictable and consistent.
2. Choose the appropriate method of beta recalibration. There are two main methods of beta recalibration: historical beta and implied beta. Each method has its advantages and disadvantages, and the choice depends on the availability and reliability of data, the assumptions and preferences of the analyst, and the consistency and comparability of the results.
- historical beta is calculated by regressing the historical returns of the asset against the historical returns of the market index over a chosen time period. Historical beta is easy to calculate and intuitive to understand, but it also has some limitations, such as:
- It assumes that the past relationship between the asset and the market will continue in the future, which may not be true if the market or the asset has changed significantly.
- It is sensitive to the choice of the time period, the frequency of the data, and the market index used for the regression, which can affect the accuracy and stability of the beta estimate.
- It may not capture the latest information and expectations of the market and the asset, as it relies on historical data that may be outdated or irrelevant.
- Implied beta is calculated by using the current market price of the asset and the expected future cash flows of the asset to derive the required rate of return of the asset, and then using the capital asset pricing model (CAPM) to solve for the beta of the asset. Implied beta is forward-looking and market-based, but it also has some challenges, such as:
- It requires the estimation of the expected future cash flows of the asset, which can be subjective and uncertain, especially for assets with high growth potential or high uncertainty.
- It requires the estimation of the risk-free rate and the market risk premium, which can vary depending on the source and the method of calculation, and can introduce errors and biases into the beta estimate.
- It may not reflect the true risk of the asset, as it may be influenced by other factors, such as liquidity, leverage, or market sentiment, that affect the market price of the asset.
3. Incorporate new information into the beta calculation. As new information becomes available, such as earnings reports, news events, analyst opinions, or market movements, it is important to incorporate them into the beta calculation to reflect the updated risk profile of the asset. There are different ways to incorporate new information into the beta calculation, depending on the method of beta recalibration used.
- For historical beta, new information can be incorporated by adjusting the time period, the frequency, or the market index used for the regression, or by using a weighted average of the historical beta and the new information. For example, if a company announces a major acquisition or divestiture, the analyst may shorten the time period, increase the frequency, or change the market index used for the regression to capture the impact of the event on the beta of the asset. Alternatively, the analyst may use a weighted average of the historical beta and the beta of the acquired or divested entity to reflect the change in the risk profile of the asset.
- For implied beta, new information can be incorporated by adjusting the expected future cash flows, the risk-free rate, or the market risk premium used for the CAPM, or by using a Bayesian approach to update the prior beta estimate with the new information. For example, if a company reports a higher or lower than expected earnings, the analyst may revise the expected future cash flows of the asset to reflect the change in the growth prospects of the asset. Alternatively, the analyst may use a Bayesian approach to update the prior beta estimate with the new information, such as the earnings surprise or the market reaction, to obtain a posterior beta estimate.