Professional Documents
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Computational Advantages
The single-index model compares all securities to a single benchmark
An alternative to comparing a security to each of the others By observing how two independent securities behave relative to a third value, we learn something about how the securities are likely to behave relative to each other
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Ri = i + i RM + ei
R P = P + PR M + eP
Beta
A securitys beta is
%% COV ( Ri , Rm ) i = 2 m % where R = return on the market index
m 2 m = variance of the market returns % Ri = return on Security i
p = i x i
i= 1
Multi-Index Model
A multi-index model considers independent variables other than the performance of an overall market index
Of particular effects interest are industry
Factors associated with a particular line of business
Multi-Index Model
The general form of a multi-index model:
% % % % Ri = ai + I m+ i I + i I + +... in I n % im 1 1 2 2 where ai =constant % I = return on the market index
m
ij = Security i beta for industry index j 's im = Security i market beta 's % Ri = retur n on Security i
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Since we know that the variance of the risk-free asset is zero and the correlation between the risk-free asset and any risky asset i is zero we can adjust the formula
E(
2 port
) = (1 w RF )
2
2 i
E( port ) = (1 w RF ) 2 i2
= (1 w RF ) i
Therefore, the standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio.
12%
8%
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
A risktaker
12%
8%
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
12%
8%
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
Portfolio Possibilities Combining the RiskFree Asset and Risky Portfolios on the Efficient Frontier E(R port ) ML
win rro Bo g C
in nd Le
RFR
E( port )
Fund Separation
Everyones U-maximizing portfolio consists of a combination of 2 assets only: Risk-free asset and the market portfolio. This is true irrespective of the difference of their riskpreferences CML
E(Rp)
(Rp
The required rate of return of a risk asset is determined by the RFR plus a risk premium for the individual asset The risk premium is determined by the systematic risk of the asset (beta) and the prevailing market risk premium (RM-RFR)
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Graph of SML
R(R i )
SML
Rm
Negative Beta
RFR
1.0
Beta(Cov im/ 2 )
M
Nonstationary Beta Problem: Difficulty tied to the fact that betas are inherently unstable
Other Problems:
(1926-2004) US Market
36
Small Stocks
Looking at that plot, small stocks appear to have higher returns. Do these stocks correctly plot on the SML?
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1 =
changes in the rate of inflation. The risk premium related to this factor is 1 percent for every 1 percent change in the rate
(1 = .01)
= percent growth in real GNP. The average risk 2 premium related to this factor is 2 percent for every 1 percent change in the rate
(2 = .02)
(3 = .03)