Stock Beta and Purchasing Power Parity: Market Analysis
Stock Beta: A Measure of Volatility
Beta is a measure of a stock’s volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
Beta is a key component for the Capital Asset Pricing Model (CAPM), which is used to calculate the cost of equity. Recall that the cost of capital represents the discount rate used to arrive at the present value of a company’s future cash flows. All things being equal, the higher a company’s beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the present value placed on the company’s future cash flows. In short, beta can impact a company’s share valuation.
Beta is calculated using regression analysis. Beta represents the tendency of a security’s returns to respond to swings in the market.
Beta Formula
KE = Rf + β(Rm – Rf)
- KE = Expected return
- Rf = Risk-free rate
- β = Beta
- Rm = Market return
To followers of CAPM, beta is a useful measure. A stock’s price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk. However, beta doesn’t incorporate new information. Another troubling factor is that past price movement is a poor predictor of the future.
Purchasing Power Parity and Exchange Rates
One of the most prominent theories of how exchange rates are determined is the theory of Purchasing Power Parity (PPP) by economist Gustav Cassel in 1918. It states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. It is simply an application of the law of one price to national price levels (which is, the assumption that free trade will equalize the price of any good in all countries; otherwise, arbitrage opportunities would exist.) Although absolute PPP ignores the effects on free trade of transportation costs, tariffs, and other restrictions.
Big Mac Index
The Big Mac Index, created by The Economist in 1986, is an illustration of the law of one price/PPP, evaluating whether currencies are at their “appropriate” levels against the dollar by comparing the prices of Big Macs worldwide. For example, if the price of a Big Mac is $4.00 in the U.S. as compared to £2.5 in the UK, it expects that the exchange rate would be 4 ÷ 2.5 = 1.60. If the exchange rate of dollars to pounds is any greater, the Big Mac Index would state that the pound was overvalued; any lower and it would be undervalued.
Real Exchange Rate
Another way of thinking about purchasing power parity is through a concept called the real exchange rate, the rate at which domestic goods can be exchanged for foreign goods. In effect, it is the price of domestic goods relative to the price of foreign goods denominated in the domestic currency. For example, if a basket of goods in New York costs $50, while the same basket in Tokyo costs $75 because it costs 7,500 yen while the exchange rate is at 100 yen per dollar, then the real exchange rate is 0.66 (50/75). The real exchange rate is below 1.0, indicating that it is cheaper to buy the basket of goods in the US than in Japan. It is the rate that indicates whether a currency is relatively cheap or not.
Limitations of PPP
Nevertheless, even if PPP provides some guidance to the long-run movement of exchange rates, it is not perfect and in the short run is a particularly poor predictor.