Hey guys, I think I understand the ‘allocating shareholder capital to pension plans’ chapter for the most part but I’m having a bit of trouble getting my head around the “total asset beta”. In particular there’s a question on Schweser’s Exam 1 PM in Volume 1 that’s throwing me (Q12.3) THe question asks which scenario would represent the appropriate reaction to increasing the pension plan allocation to equity, if the firm wants to maintain it’s current equity beta. The scenario they present as the answer is as follows: Debt to equity decreases - I follow this, to offset extra risk in the pension plan the operating part of the firm must become less risky. Equity beta stays constant - given as part of the question Amount of equity capital constant - not totally ok with that, but it’s fine once debt decreases Total assets beta increases - this part I don’t follow, surely if they’re keeping the overall risk of the firm constant then the total assets beta should be the same? Can anyone shed some light?
Equity beta and total asset beta are not the same number unless there is no debt.
Hmm… not sure I remember this part, but I assume this is about how your total asset portfolio changes with whatever the beta benchmark is. So if you have an all equities portfolio and beta is measured vs. the S&P500, then total asset beta is going to be the same as your equity beta. Now if you have a 60/40 portfolio, the bond part of the portfolio might covary somewhat with the S&P, but probably not as much as the equity portion. So your total asset beta is likely to be lower than the beta of the equity portion, which I am assuming is the equity portion. Would that be correct, or is there something big I’m missing there?
Key is not the makeup of the pension portfolio, but the capital structure of the company. B/S: asset = debt + equity therefore asset beta = weighted avg of debt beta and equity beta only way asset beta = equity beta is if debt = 0 In above, asset refers to company’s b/s assets, not pension plan assets.
Ah, ok… now I understand the reference. Yes… asset beta is the beta of a company assuming no debt on the balance sheet. It’s a way of comparing the operational risk of companies independent from their capital structure (i.e. controlling for financial risk), and is useful for coming up with the “risk of comparable companies in the same industry”.