# Financial risk and beta?

Why does an increase in financial risk increase the stock’s beta?

hmm, let me see if i can give this a shot: stock’s beta is simply the cov(stock, market) /SDmarket. Stocks financial risk is a risk that can’t be eliminated by diversifying in the market. Hence stocks’ financial risk increases the stock beta.

Ok may be what I said makes no logical sense, but I know there is a link in there with systematic risk vs unsystematic risk. wait for CPK. I think cpk will be the first one ever in the history to get 100% on CFA exam. CFA claims that there has never been a candidate like that.

my way of looking at it: (may not be correct at all) Increasing financial risk means more return demanded by the market. return demanded = rf + beta(rm-rf) all the other terms are fixed, rf and rm. so increased return means increased beta. crude… but know of nothing else. pepp - also in your formula above beta = cov(stock,market)/variance market - not sd market. = rho * sd stock / sd market.

I agree, cpk will be the first ever to score 100% on the exam, obliterating CFAI’s claim forever. That explanartion makes sense to me.

So I guess that means stocks with high D/E ratios have higher betas than stocks with lower D/E ratios?

yes Dreary, this is also explained by the pure play method from level 1 or as they call in level 2, the build up model Basset = Bunlevered * ( 1 + (D/E))

Think of two identical companies, except one has more FC and more debt. What this means then is that as markets fluctuate the NI (i.e. return) of this company will be much more volatile and sensitive to changes in sales. Hence, when the the overall economy rises by say 1% and the sales and NI of the unlevered low FC company rise by 1% also the NI of the levered and high FC may jump 2% or more. What this does then is increase the absolute value of the covariance term in the beta numerator for this company relative to the unlevered low FC company, this of course causes the Beta of this company to be correspondingly higher than that of the unlevered/low FC company. The crucial step can be shown by using: Cov(a,b)=E[(Ra-E(Ra))(Rb-E(Rb))]

TheAliMan Wrote: ------------------------------------------------------- > Basset = Bunlevered * ( 1 + (D/E)) What’s this equation all about? which page? is this L2 at all?

SS10 and Corp Finance. How to lever and unlever beta I guess

grrr… I have SS10, since a very long time on my todo list.

> = rho * sd stock / sd market. PS I just about sh!t myself when I saw this, my reaction (since I had been working on derivatives) “What the fuk does option sensitivity to the risk free rate have to do with a stock’s beta?” No worries, I quickly figured out you meant the correlation coefficient! LOL, this sh!t is melting my brain.

higher financial risk implies higher required return to justify this risk required return = Rf + beta(Rm - Rf) Rm and Rf are not dependent on the stock. So in order to get higher required return, you need higher beta.