Basics of Corporate Finance

Beta is equal to the slope

The slopes of the lines show how much the return of each stock moves in response to movement in the return on the market as a whole. A security's beta is equal to the slope on this type of graph. There are several different ratings companies that calculate and publish the beta coefficients for thousands of companies.

If a company with a beta coefficient greater than 1.0 is added to an average-risk portfolio, the overall risk of the portfolio will increase. On the other hand, adding a stock with a beta coefficient less than 1.0 will reduce the overall risk of an average-risk portfolio.

Example
Let's analyze a simple example to organize what we have learned. Suppose we have the following information for stock X and stock Y.

We know the following about stock X and stock Y:
1) Beta represents systematic risk. Stock X has less systematic risk than stock Y.
2) Standard deviation represents total risk. Stock X has more total risk than stock Y.
3) Total risk equals systematic plus unsystematic risk. Stock X must have more unsystematic risk than stock Y.
4) Investors earn a return on systematic risk. Stock Y will have a higher expected return and a higher risk premium even though its total risk is less than the total risk of stock X.

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