Question

If portfolio manager wants to hedge with a stock index futures, the optimal hedge is based on Beta. Very briefly state why “THE CAPM-BETA” may NOT be right to consider.  

Answer 1

Hedging refersto buying an investment designed to reduce the risk of losses from another investment .Investors will buy an opposite investment to do this such as by using a put option to hedge against losses in a stock position since a loss in the stock will be somewhat offset by a gain in the option . Technically speaking Beta is a measure of stock price variability in relation to the overall stock market .Beta is calculated by regressing the percentage change in stock prices versus the percentage change in the overall stock market CAPM beta is a theoretical measure of the way how a single stock moves with respect to the market by taking correlation between the both , market represents the unsystmatic risk and beta represents systematic risk. The CAPM is the standard risk return model used by practitioners. The objective of the study is to test the validity of this theory in Indian capital market and the stability of this non diversified risk .THE CAPM-BETA may not be right to consider because it has serious limitations in real world as most of the assumptions are unrealistic .Many investors do not diversified in a planned manner .Besides beta coefficient is unstable varying from period to period depending upon the method of compilation .CAPM cannot be used in isolation because it simplifies the world of financial market.Financial managers can use it to supplement other techniques and their own judgment in their attempts to develop realistic and useful cost of equity calculations.