Market Risk & SCBA: Concepts, Measurement, Approaches

What is Market Risk?

Market risk is the only widely accepted, theoretically derived measure of risk in finance. A firm’s market risk, more commonly known as “beta”, stems directly from the Capital Asset Pricing Model (CAPM). Simply put, market risk measures the degree to which a stock’s returns co-vary with the returns of the overall market portfolio comprising all assets in the economy.

This is a systemic risk, meaning it cannot be diversified away, and therefore it is priced into financial models. A stock with a lower beta typically has a lower cost of capital and, consequently, a higher firm value. Despite its limitations, CAPM continues to be a widely used tool among practitioners for estimating the cost of equity capital.

How is Market Risk Measured?

The CAPM framework involves expected stock returns and expected market returns. However, to estimate beta, historical stock returns are commonly used. Market returns are proxied using the value-weighted returns of all traded stocks in the economy.

In addition to stock returns, data on the risk-free rate often represented by Treasury bond returns is required. The following linear model is then estimated using Ordinary Least Squares (OLS):

Rit = α + βMktt

Where:

Rit = excess stock return over the risk free rate
Mktt = excess market return over the risk free rate
β = estimate of market risk

Typically, CAPM is estimated using monthly returns. To obtain reliable beta estimates, a sufficiently long time series of 36–60 months is preferred. If fewer observations are available, weekly returns can be used. Some researchers also use daily returns, but such data often exhibit serial correlation, which must be addressed when estimating CAPM.

Social Cost Benefit Analysis (SCBA)

The primary objective of an individual, firm, or company investing in a project is to maximize returns. Project promoters, therefore, often focus solely on commercial profitability. However, certain projects may not offer attractive financial returns but still hold significant social value for example, roads, railways, and power projects.

These are evaluated in terms of their net socio-economic benefits, a process known as National Profitability Analysis or Social Cost Benefit Analysis (SCBA), conducted at the national level.

Scope of SCBA

Public Investment: Particularly relevant in developing countries where governments play a major role in economic development.
Private Investment: SCBA is also required for private investments that need approval from governmental or quasi-governmental agencies.

Objectives of SCBA

SCBA primarily aims to evaluate:

Economic benefits of the project in terms of shadow prices.
The project’s impact on the level of savings and investment in society.
Its effect on the distribution of income within the community.
The project’s contribution to fulfilling merit wants, such as self-sufficiency, employment generation, and national development.

Role of SCBA

Improves transparency in decision-making.
Explains and communicates why results are presented in a particular way.
Provides a framework to compare and weigh project effects.
Offers insights into both individual and aggregate outcomes.
Encourages open discussion among stakeholders and decision-makers.

Approaches to SCBA

Two principal approaches are used in Social Cost Benefit Analysis:

1. UNIDO Approach

Developed by the United Nations Industrial Development Organization (UNIDO).
Emphasizes the evaluation of projects from the perspective of economic development, especially in developing countries.
Focuses on:

Adjustment of financial prices to shadow prices (reflecting real economic value instead of market distortions).
Assessment of foreign exchange effects, savings, and income distribution.
Consideration of social objectives like employment generation and regional development.

It uses a step-by-step project appraisal approach, making it systematic and widely adopted in international organizations.

2. Little–Mirrlees (L-M) Approach

Proposed by Ian Little and James Mirrlees in their work on project appraisal for developing economies.
Based on shadow pricing and efficiency prices to correct market imperfections.
Key focus:

Projects are evaluated in terms of their impact on national income.
Emphasizes cost-benefit calculations at world prices, assuming international trade is the most reliable measure of value.
Strong focus on the opportunity cost of resources.

It is more theoretical and rigorous compared to the UNIDO method.

In short:

UNIDO Approach → Practical, step-by-step method suitable for policy and planning in developing countries.
L-M Approach → Theoretical, efficiency-based, focusing on resource allocation using world prices.

Comparison: UNIDO vs. Little–Mirrlees (L-M) Approach

Aspect	UNIDO Approach	Little–Mirrlees (L-M) Approach
Origin	Developed by United Nations Industrial Development Organization (UNIDO)	Developed by Ian Little and James Mirrlees
Perspective	Focuses on economic development of a country, especially developing nations	Focuses on efficiency in resource allocation
Methodology	Step-by-step project appraisal framework	More theoretical and rigorous, based on shadow pricing
Use of Prices	Adjusts financial prices to shadow prices	Uses world prices as a basis for valuation
Focus Areas	Employment, income distribution, savings, foreign exchange effects, regional growth	Opportunity cost of resources, efficiency, and impact on national income
Application	Widely used in policy planning and development projects	More suitable for academic research and efficiency-focused project appraisal
Practicality	Practical and systematic for real-world projects	Theoretical and technical, less practical for policymakers

Conclusion

Both Market Risk and Social Cost Benefit Analysis (SCBA) are essential frameworks for evaluating investment decisions, but they approach the process from different perspectives.

Market Risk (Beta under CAPM) focuses on the financial side of investment, measuring how much risk a stock carries relative to the overall market. It helps firms and investors determine the appropriate cost of equity and make efficient portfolio choices.
SCBA, on the other hand, extends beyond financial profitability to assess the wider economic and social impact of projects. It ensures that investments, especially in public infrastructure or socially significant sectors, contribute to long-term development and welfare.

Together, these approaches highlight the balance between financial returns and societal benefits, guiding decision-makers to choose projects that are not only profitable but also sustainable and equitable for society at large.

FAQ's

What is market risk in simple terms?

Market risk is the risk of losses due to changes in overall market conditions. It reflects how sensitive a stock’s returns are to market-wide movements and is measured by beta under the CAPM model.

Why is beta important in finance?

Beta shows whether a stock is more or less volatile than the market. A beta greater than 1 means the stock is riskier than the market, while a beta less than 1 means it is relatively safer.

How is beta estimated?

Beta is usually estimated using historical data on stock returns and market returns, with the risk-free rate (like Treasury bonds) as a benchmark. The CAPM equation helps calculate it.

What is Social Cost Benefit Analysis (SCBA)?

SCBA is a method to evaluate projects by considering both financial and social impacts. Unlike traditional profitability analysis, it accounts for broader economic and social benefits.

Why is SCBA important for public projects?

Public projects like roads, railways, and power plants may not be highly profitable commercially but can generate significant social and economic benefits. SCBA ensures these are properly measured before approval.