IIBMS – The Beta for American Standard

CASE 5: IIBMS – The Beta for American Standard IIBMS – The Beta for American Standard Joey Moss, a recent finance graduate, has just begun his job with the investment firm of Covili and Wyatt. Paul Covili, one of the firm’s founders, has been talking to Joey about the firm’s investment portfolio. As with any investment, Paul is concerned about the risk of the investment as well as the potential return. More specially, because the company holds a diversified portfolio, Paul is concerned about the systematic risk of current and potential investments. One position the company holds is stock in American Standard (ASD). American Standard manufactures air conditioning systems, bath and kitchen fixtures and fittings and vehicle control systems. Additionally, the company offers commercial and residential heating, ventilation, air conditioning equipment, systems, and controls. Covili and Wyatt currently uses a commercial data vendor for information about its positions. Because of this, Paul is unsure exactly how the numbers provided are calculated. The data provider considers its methods proprietary, and it will not disclose how stock betas and other information are calculated. Paul is uncomfortable with not knowing exactly how these numbers are being computed and also believes that it could be less expensive to calculate the necessary statistics in-house. To explore this question, Paul has asked Joey to do the following assignments: Go to finance.yahoo.com and download the ending monthly stock prices for American Standard (ASD) for the last 60 months. Also, be sure to download the dividend payments over this period as well. Next, download the ending value of the S&P 500 index over the same period. For the historical risk-free rate, go to the St. Louis Federal Reserve Web site (www.stlouisfed.org) and find the three-month Treasury bill secondary market rate. Download this file. What are the monthly returns, average monthly returns, and standard deviation for American Standard stock, the three-month Treasury bill, and the S&P 500 for this period? Beta is often estimated by linear regression. A model often used is called the market model, which is: Rt ─R¦t  = αi + Βi  [RMt ─ R¦t] + εt In this regression, Rt is the return on the stock and R¦t  is the risk-free rate for the same period. RMt is the return on a stock market index such as the S&P 500 index. αi is the regression intercept, and Βi is the slope (and the stock’s estimated beta). εt represents the residuals for the regression. What do you think is the motivation for this particular regression? The intercept αi is often called Jensen’s alpha. What does it measure? If an asset has a positive Jensen’s alpha, where would it plot with respect to the SML? What is the financial interpretation of the residuals in the regression? Use the market model to estimate the beta for American Standard using the last 36 months of returns (the regression procedure in Excel is one easy way to do this). Plot the monthly returns on American Standard against the index and also show the fitted line. When the beta of a stock is calculated using monthly returns, there is a debate over the number of months that should be used in the calculation. Rework the previous questions using the last 60 months of returns. How does this answer compare to what you calculated previously? What are some arguments for and against using shorter versus longer periods? Also, you’ve used monthly data, which are common choice. You could have used daily, weekly, quarter, or even annual data. What do you think are the issues here? Compare your beta for American Standard to the beta you find on finance.yahoo.com. How similar are they? Why might they be different? 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