High beta vs. Low beta

MSharky

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Hi

Why is it that companies that produce elastic goods/services (i.e. luxury items) tend to have higher betas than those that produce inelastic products. I am just trying to understand the logic behind this.

Thanks,

Moe
 
Hi MSharky,

It is because the demand for products with high demand elasticity is more volatile than inelastic goods. For example; when economy is good (e.g.; low unemployment, higher wages) households will more likely consume luxury goods but they will also quit consuming these goods first when the economy turns weaker. Thus, companies that produce goods with more volatile demand will experience more volatile earnings and stock returns (hence, higher beta). Companies that produce goods with stable demand (e.g.; medical supplies, education) will not experience such volatility in earnings (hence, the lower beta).
 

MSharky

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Thanks, that makes sense. Thinking about it from the CAPM perspective, higher expected return can be attributed to a higher systemic risk (beta)
 

FRM Bionic Ninja Turtle

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Agree with Gyilmaz, but theoretically speaking "economy" per se is a statistical dependent variable, while under normal condition it has a heavy weight-age to be considered for such case - high betas for elastic goods and low betas for inelastic good.
However, the controversy part - is when such a weight-age is low and there are other unpredictable factors(i.e. disaster, policies change, inherent issues in third-world ctry) affecting the so-called resilience industry such as education.

Correct me.
 
Hi Ninja,

If I am getting your question right, since beta is related to the covariance of a firm's stock or assets with the market and the variance of the market, betas will change due to an external shock (covariances and variance of market will change). Also, demand elasticity for various goods will change. Some inelastic goods may become more inelastic (people will look for bread and nobody will care about gluten anymore, so wheat bread will become even more inelastic). Some elastic goods may become even more elastic (e.g.; luxury cars) or inelastic . Which will happen is hard to predict because it all depends on the nature of the external shock which itself is unpredictable. Thus, historical betas might become less meaningful. Some historically high beta firms may become low beta and, vice versa.
 

FRM Bionic Ninja Turtle

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Subscriber
Yes, well articulated.

Just to add, in my ppersonalopinion as I believe CAPM itself is a model that might be reliant on some parameters incl. historical betas and few "implied" factors, but what we might not be aware of , is what the future beholds, while it wouldn't affect these parameters to full extent which absolutely requires fine-tuning to the model, yet we must not forget about the progressive changes affecting the "implied" factors and how these affect the parameters.

Disclaimer: My opinion doesn't suggest that it is an outdated model or impractical in the modern banking world, its just an opinion.

Correct me again if I'm wrong.
 
I agree Ninja. CAPM has very strong assumptions. For example, it is a one-period model that does not incorporate any priors which may feed into shaping future betas and the state of the market. Clearly, it does not include all risk factors and that's why we have other factor models. Models can be fine-tuned to capture more reality at the expense of getting more complicated and sometimes they will lose generality. So, it is a trade-off and the user of the model has to make a choice.
 
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