The relationship between accounting determined risk measures and market-determined equity beta
An investment decision is the most crucial aspect of financial management. Consequently, financial economists strive to improve the modelling of financial markets to make better investment decisions. A very important parameter of investment decision is a risk. Even though the academic interest in risk goes as far back as the 18th century to the time of Daniel Bernoulli, a numerical and analytical model did not evolve till the 1950s when the work of Markowitz, Sharpe and Lintner culminated in the most influential capital asset pricing model (CAPM). CAPM asserts that the risk-averse investors form portfolios and only risk that matters is the systematic risk measured by systematic beta. In the CAPM world, beta is the covariance of a stock’s return to the market portfolio standardized by the variance of the market portfolio.
However, CAPM does not provide any information regarding the underlying factors that affect beta. The understanding of the underlying economic factors that affect beta has been the focus of many researchers since the advent of CAPM. Since the accounting data is generally considered capturing the underlying economic factors, the relationship between beta and the accounting variables is very important and has also been the focus of the researchers since 1970.
Accounting is defined as the systematic process of measuring the economic activity of the business to provide information to those who make economic decisions and financial accounting provides information to external users like investors to make informed investment decisions.
Researchers have shown the importance of accounting information in evaluating firms by showing that investors prefer accounting determined risk measures in their risk analysis and have suggested that investors use accounting determined risk measures as surrogates for risk. They also evidenced that 90% of the explanatory power of the market based financial risk models can be captured by relatively parsimonious accounting-based models.
The identification of the relationship between accounting determined risk measures and market-determined equity beta is important for the following reasons.
The instability of market betas over time means that they are not a good predictor of future risk and the identification of the relationship between accounting variables and market beta can improve predictive models of future risk.
Secondly, our knowledge of risk determination is incomplete without knowing the exogenous variables or non-price data that are impounded in the stock prices and price changes.
Thirdly, If the accounting determined risk measures can explain the market-determined risk measures, investors and managers can rely on the accounting-based risk measures during periods of instability in the market or absence of market risk measures as in the case of private companies, IPOs and divisional capital budgeting. Even when market risk measures are available, accounting determined risk measures can be used to complement and verify them.