However if the historical beta is calculated using say 5 years of monthly data

However if the historical beta is calculated using

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However, if the historical beta is calculated using say 5 years of monthly data, and if the company changes its capital structure toward the end of the 5 year period, then the historical beta may not reflect the risk for the company in the future, which is what we are really interested in. Other fundamental factors such as the type of assets the company is investing in, or conditions in its industry (such as the electric utilities as they make the transition from regulated monopolies to competitive companies) could also cause the future beta to differ from the historical beta. Rosenberg and others (for example, Ibbotson Associates) who work with fundamental betas sell those betas rather than give them away—they are proprietary products, so little research has been reported on whether a fundamental beta calculated in 2006 is a better or worse predictor of the actual beta during 2007 and thereafter. Beta sellers, of course, argue that their betas are best, but who really knows? Since there are often substantial differences between betas calculated for a given company, and since different betas plugged into the SML equation result in different Answers and Solutions: 3 - 3
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estimates of the required rate of return, it certainly can matter which beta is used. However, as noted above, we really don’t know what beta best reflects the view of “the marginal investor,” hence is used to establish returns on actual stocks. Of course, we don’t even know if the SML itself is used, either! Students should be aware of all this, and be aware of the effects of using different CAPM inputs in actual applications such as finding the cost of equity for a company. 3-6 As noted above and in the text, the CAPM has not been empirically verified. The biggest problem, in our minds, is that the theory is based on expectations, yet the tests generally use historical data. We support the CAPM concept because of its logical appeal in spite of the fact that it has not been empirically verified, although we recognize the difficulties encounter when attempting to implement it. We think the CAPM should be used, but its results should be regarded as approximations, not precisely accurate numbers. Also, we think that other factors should be considered, as discussed in the latter part of the chapter. 3-7 A diversifiable risk is a risk that can be eliminated by diversification, while a non- diversifiable risk is one that cannot be diversified away. Market risk is the non- diversifiable risk of most concern in financial analysis. Note, though, that derivative securities have been developed that can be used to help eliminate market risk. Thus, puts and the like can be used to protect a portfolio against market declines. Companies such as the one started by Professor Rosenberg have created “portfolio insurance” using derivatives. However, 1) it is expensive to use derivatives, 2) it might be possible for a few investors to use them to lower their portfolios’ risk, but it
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