Archives - Mathematics: Page 7
Author: rhyco5 (Fri Mar 16, 2007 12:23 pm)
Title: Finance
This is for you finance majors. Usually math is something that his little relevance with reality, but in finance math is related directly to stock and performance information. For example, take into account the meaning and calculation of beta; the measure of a stocks risk in relation to the overall market. However, if you think about it intuitively while comparing two companies then this might not make to much sense. Wachovia has a beta of .8 and McDonald's has a beta of 1.2. This would mean that holding McDonald's in your portfolio is a greater risk than Wachovia and has the potential to do the most damage to your portfolio. At the moment Wachovia is about 70% debt and they are still buying other banks giving them a high chance of defaulting on their loans. Lets use another example, in the case of a depression citizens will start pulling their monies out of banks because they could not ensure everyones money, causing the bank to default on their loans and go under. Now in the same scenerio McDonald's deals in food all over the world. In the case of a Depression poeple still need to eat. Even homeless people find their way to Micky D's. McDonald's would lose some profits but wouldn't hurt your porfolio as much.
Beta does measure the risk involved with a particular stock or index (as in the CAPM formula). However, you can't use a company in the Financial Services industry for comparison to one in the Restaurant industry. In response to your bank run scenario due to economic depression: that is why the government created FDIC insurance to cover account holders up to $100,000. For most Americans, this covers 100% of an account balance. For wealthier citizens, this 100,000 maximum is easily side-stepped by moving funds around through several accounts. If you were insured for up to 100,000 dollars, would you withdrawal your money during a depression? Of course not. Especially when you could be earning interest on that money.
Second, in addition to measuring risk, beta is also used to measure the risk premium of a stock in relation to a market's risk premium, or excess returns. For example, McDonalds currently has a beta of 1.35. This means that their returns SHOULD exceed market returns by approximately 1.35.
This makes perfect sense because, as you know, when an investor assumes more risk, they expect the possibilty of higher returns.