why is asset volatility lower than equity volatility??
- Thread starter itsyourz
- Start date
suk,
I don't think our assignments speak to this at all.
But, asset value = F[operating income; e.g., EBITDA] while equity value = F[operating income - interest on debt]. By f[] i mean, asset value is a multiple of EBITDA, equity value is multiple of after-tax earnings.
The interest expense, which must be paid, is like leverage on the earnings. If EBIT/EBITDA is volatile, then subtracting interest expense, can only be at least as volatile or more volatile.
for this reason, equity beta > asset beta. And if CAPM: e(r) = a + beta*ERP, then variance of return = beta^2*variance(ERP). So volatility scales with beta. Higher equity beta = higher equity volatility.
or, to be less mathematical, maybe think about the private equity MBO/LOs: the financial engineering is to take on debt to lever up the returns. given the same asset value and volatility, adding the leverage increases both expected return but also equity volatilty
hope that helps (but we didn't study it!)
David
I don't think our assignments speak to this at all.
But, asset value = F[operating income; e.g., EBITDA] while equity value = F[operating income - interest on debt]. By f[] i mean, asset value is a multiple of EBITDA, equity value is multiple of after-tax earnings.
The interest expense, which must be paid, is like leverage on the earnings. If EBIT/EBITDA is volatile, then subtracting interest expense, can only be at least as volatile or more volatile.
for this reason, equity beta > asset beta. And if CAPM: e(r) = a + beta*ERP, then variance of return = beta^2*variance(ERP). So volatility scales with beta. Higher equity beta = higher equity volatility.
or, to be less mathematical, maybe think about the private equity MBO/LOs: the financial engineering is to take on debt to lever up the returns. given the same asset value and volatility, adding the leverage increases both expected return but also equity volatilty
hope that helps (but we didn't study it!)
David
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