InvestorQ : What is the relationship between beta and excess return?
Chandralekha Desai made post

What is the relationship between beta and excess return?

Nishita Gala answered.
1 year ago
The beta of a stock is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns. In CAPM, beta is the constant of proportionality between the annual relative portfolio return, alpha, and the market premium. The portfolio return and the market premium are both measured relative to the risk-free rate (RRR).

In formula: Alpha (Excess return) = (Annual Portfolio Return - RRR) - beta * (Annual Index Return - RRR).

The bulk of the CAPM formula (everything but the excess-return factor) calculates what the rate of return on certain security or portfolio ought to be under certain market conditions. It should be noted that two similar portfolios might carry the same amount of risk (same beta) but because of differences in excess return, one might generate higher returns than the other. This is a fundamental quandary for investors, who always want the highest return for the least amount of risk.

To explain in simpler terms, if the Beta of a stock is 1 then it means that the stock moves in line with the index. The beta of 1.2 means that the stock is 20% more volatile than the index. Conversely, a stock Beta of 0.8 will mean that the stock is 20% less volatile than the market as a whole.