Index Models

Chapter 10
10-2

The Need for a Simpler Model

the input list (i.e., list of assets on the market) in the Markovitz portfolio selection model is very important, determining the accuracy of finding efficient portfolios _ however, it involves a lot of calculations _ for example, for n = 50 assets we need to
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calculate (or, more precisely, estimate):

n = 50 expected returns _ n = 50 variances _ n(n 1) / 2 = 1225 covariances
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in total, n(n + 3) / 2 = 1325 estimates!

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10-3

The Need for a Simpler Model (cont.)

also, because we estimate returns, variances and covariances, small errors can have large effects
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for example, if we estimate wrongly the covariance matrix (mutually inconsistent correlation coefficients), it is possible that the variance of the portfolio we construct is negative! _ hence, the need for a simpler model, that doesnt rely on calculations that many calculations
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10-4

The Single-Factor Model

security returns tend to move together because of market risk _ suppose we can summarize all the common effects into one macroeconomic variable _ then we can write the return on stock i as ri = E(ri) + mi + ei where mi is the unanticipated effect of the common macroeconomic factors, and ei is the
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unanticipated effect of firm-specific factors _ note that E(mi) = E(ei) = 0

10-5

The Single-Factor Model (cont.)

different firms have different sensitivities to macroeconomic events _ denote the sensitivity of firm i to the common set of factors (sensitivity coefficient) by i _ denote the variable that encompasses the
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unanticipated effect of the common set of macroeconomic factors by F _ then mi = i F and the equation for the return on stock k becomes the single-factor model: ri = E(ri) + i F + ei
10-6

The Single-Index Model

now, we need a measure for F, the common macroeconomic factors _ since a market index corresponds to a welldiversified
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portfolio, its return should respond only to the common macroeconomic factors _ hence, we can use a market index (say, S&P 500) to approximate our macroeconomic variable _ the single-index model _ investors are more interested in risk premiums rather that returns
10-7

The Single-Index Model (cont.)

then we can write the return on stock k as ri rf = i
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+ i [rm rf] + ei or: Ri = i + i Rm + ei where Ri, Rm are excess returns _ we can decompose the excess return on a security into three components:
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i
= return if the excess return on the market portfolio is zero
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i
[rm rf] = return due to market movements _ ei = return due to unexpected firmspecific factors
10-8

Why Beta?
covariance between returns on stock k and market portfolio (index): _ hence,
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2

0),(0 ),(),(),( ),( ),( ),(),(),(

mi mmi mimmimi mimii mi fmfimfimi

R R Cov R e Cov R R Cov R Cov R e R Cov R R Cov r r r r Cov r r r Cov r r Cov

= ++ = ++ = ++ = = = =
2

),(
m mi i

r r Cov

10-9

Return Variance and Covariances

note that the variance of returns is _ hence, there are two sources of risk: _market (idiosyncratic) risk: i
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2

m
2

_
2

firm-specific risk: ei

covariance between returns on stocks i and j: 2 2 2 2 ) ( ei m i i m i i i e R Var

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+ = + + = ),( ),(),(
mji jmjjimii jiji

e R e R Cov R R Cov r r Cov

++ + + = =
10-10

Why Is It a Simpler Model?

the input list for n = 50 assets consists of:
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n = 50 estimates of expected returns _ n = 50 estimates of sensitivity coefficients ( i ) _ 1 (one) estimate of the variance of the market portfolio (index) _ n = 50 estimates of firm-specific risks (
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ei
2)

in total, 3n + 1 = 151 estimates, as compared to 1325!

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10-11

Advantages and Disadvantages

_ Advantages:

easier to generate the Markovitz frontier _ allows the specialization of security analysts by industry
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_ Disadvantages:

overly simplistic decomposition of risk macro

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vs. micro (ignores, for example, industry specific events) _ resulting portfolios might be inefficient
10-12

Estimating the Index Model

the single index model equation has the form of a regression equation: Rit = i + i Rmt + eit _ this defines a line with intercept i and slope
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, with eit being the deviations from the line for the individual returns _ this line is called the Security Characteristic Line (SCL) _ it can be estimated using standard estimation techniques
10-13

Estimating the Index Model (cont.)

_
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to do that, follow the steps:

gather historical data on stock prices (usually closing price), market index and risk-free asset

(T-bills) _ construct one-period returns (for a onemonth or one-week holding periods) for the stock, the market index and the risk-free asset _ this yields the variance of the return on the market index _ construct excess returns for the stock and the market index _ estimate the index model equation and obtain estimates of i , i , and ei
2

10-14

Security Characteristic Line

Ri Rm SCL

10-15

Portfolio Risk
the single index model equation for a portfolio has the same form: Rp = p + p Rm + ep where p, p, and ep are weighted returns of the individual stock counterparts _ the variance of the firm-specific term ep
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decreases as the number of stocks included in the portfolio increases _ this is another example of the effects of diversification on risk
10-16

The Effect of Diversification on Risk

Diversifiable risk Market risk number of assets

p
2
2 2

p m

10-17

Problems with the CAPM

remember that the CAPM holds that E(ri) = rf + i [E(rm) rf] _ implication of the CAPM:
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the market portfolio is efficient _ relationship between risk and expected returns
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in practice, the CAPM is not directly testable, because it makes prediction about ex ante returns, while we only observe ex post returns
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10-18

Testing the CAPM using the Index Model

remember that the beta coefficient in the index model is the same as the beta in the CAPM _ we can write the index model equation as ri rf = i + i [rm rf] + ei _ take expectations of both sides: E(ri) rf = i + i [E(rm) rf] _ according to CAPM, a stocks should be equal to zero, on average
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hence, we should find that our estimates of s are centered around zero (Jensen, 1968)
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10-19

Estimated Alphas
10-20

More Practical Insights

the beta coefficient, variances of return on market index and of firm-specific deviations can be estimated from historical data _ a source of such information is Merrill Lynchs
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Security Risk Evaluation book (beta book) _ differences from index model:
uses returns rather than excess returns _ ignores dividends
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10-21

Adjusted Beta
estimated beta coefficients tend to move toward one over time _ reasons:
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average beta for all stocks is 1 (market beta) _ firms become more diversified over time _ they eliminate more of firm-specific risk
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Merrill Lynch calculates an adjusted beta to compensate for this tendency: where a and e are adjusted and estimated betas, respectively 3 1 3 2 + = ea
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10-22

Tracking Portfolios
suppose an investor identifies an underpriced
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portfolio P ( p > 0) and wants to invest in it _ still, if the market as a whole declines, she would still end up losing money _ to avoid that, she can construct a tracking portfolio T, with the following structure:
a proportion p in the market index _ a proportion (1 p) in the risk-free asset
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since T is constructed from the market index and the risk-free asset, its alpha coefficient is zero
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10-23

Tracking Portfolios (cont.)

next, she can buy P and short-sell T at the same time _ eliminates the market risk _ still, the investment will yield a return (because of the portfolio Ps positive alpha) _ note: the portfolio is not risk-free it still has the firm-specific risk _ this strategy is what many hedge funds do
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