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Index Models: Juan Sotes-Paladino FNCE30001 Investments
Index Models: Juan Sotes-Paladino FNCE30001 Investments
Index Models
Juan Sotes-Paladino
FNCE30001
Investments
Semester 2 2015
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Overview
Motivation
Todays Class...
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Overview
Motivation
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Overview
Motivation
Main problem is that estimation error can make Markowitz model almost useless
Remember: covariances most likely estimated from past data
Estimates will look like confidence intervals: e.g.,
BHP,QANTAS [0.346, 0.592]
wBHP
and wQANTAS
can vary a lot depending on the value of
BHP,QANTAS in
[0.346, 0.592] we use!
Problem can get so serious that simply equal-weighting the assets (w = 1/N) in a
portfolio can do much better
DeMiguel, Garlappi & Uppal, 2007, Optimal Versus Naive Diversification: How
Inefficient is the 1/N Portfolio Strategy? Review of Financial Studies.
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Overview
Motivation
A Solution
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Start by expressing the rate of return on a security as the sum of its expected and
unexpected parts:
ri = E (ri ) + ui
where ui measures the unexpected component of security returns, with:
E (ui ) = 0
Var (ui ) = i2
e.g., if the expected returns was 5% and the actual return turned out to be 7%, the
unexpected component was 2%.
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
A Common Factor
The returns on jointly normally distributed securities are linearly related to one or
more common factors
A macroeconomic variable, denoted by m, that captures unanticipated macro
surprises:
2
E (m) = 0, var (m) = m
In this case, we can further decompose uncertainty ui into uncertainty about the
economy as a whole (m) and uncertainty about the firm ei
ri = E (ri ) + i m + ei
| {z }
ui
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Properties of m:
Has no subscript, because it affects all securities
Not correlated with firm specific risk: for all i, cov (m, ei ) = 0
Index Models
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Each major market has at least one index we could use for m:
Australia: All Ordinaries, S&P/ASX 200
US: S&P 500, Dow Jones
London: FTSE 100
Japan: Nikkei 225
Germany: DAX
Index Models
10
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
How do we estimate ?
We need to estimate systematic risk, beta:
Estimations of i are key to estimate variances and covariances
Easy to do when we have past data for the index
Let us define
Ri ri rf
RM rM rf
Ri (t) = i + i RM (t) + ei (t)
The Single Index Model
Defines a security characteristic line (SCL) for asset i: Regression line of best fit
through a scatterplot of rates of return for an individual risky asset (i) and for the
market portfolio of risky assets (M) over some designated past period
University of Melbourne FBE
Index Models
11
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Index Models
12
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Risk Premium
Taking the expected return of the regression equation, we have:
E (Ri ) = i + i E (RM )
Looks familiar?
Part of a securitys risk premium E (Ri ) is from the risk premium of the index
E (RM ): i E (RM )
According to the CAPM, this should be the only risk premium
Index Models
13
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Diversification
Index Models
14
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
RP = P + P RM + eP
P =
N
1 X
i
N i=1
P =
N
1 X
i
N i=1
eP =
N
1 X
ei
N i=1
2
P2 = P2 m
+ 2 (eP )
University of Melbourne FBE
Index Models
15
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
P2 =
1
N
PN
i=1
2 (ei )
For a sufficiently large number N, this average should remain relatively constant
as we add more stocks to the portfolio
Empirically,
P2 for N = 50 generally very close to
P2 for N = 100
N
1 X
E [ei ] = 0
N i=1
P = var
N
N
1 X
X
1
ei = 2 var
ei
N i=1
N
i=1
N
1 X 2
(ei )
2
N i=1
1 2
N P
Index Models
16
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Limits to Diversification
As N increases,
P2 is unchanged but 1/N approaches 0 quickly
Thus, as N increases, 2 (eP ) =
1 2
(e)
N
Index Models
17
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Index Models
18
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Index Models
19
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Market
rf
Index Models
20
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Treynor & Black (73) solution: The optimal risky portfolio is a combination of:
An active portfolio, denoted by A: comprises the n analyzed securities
Follows from security analysis
The market index (passive) portfolio, denoted by M: the (n + 1)-th asset included
to aid in diversification
University of Melbourne FBE
Index Models
21
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
The ratio of a portfolios alpha to its residual standard deviation is called the
A
information ratio, (e
A)
Extra return we can obtain from security analysis compared to the firm-specific risk
we incur when we over- or underweight securities relative to the passive market index
The intuition is then that, to maximize the Sharpe ratio of the risky portfolio, the
information ratio of the active portfolio needs to be maximized
Achieved by investing in each security in proportion to its ratio of
i
2 (ei )
In turn, the weight of the active portfolio in the optimal overall risky portfolio P is
proportional to its ratio of 2(eA )
A
Index Models
22
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Index Models
23
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
N
X
wi i
i=1
N
X
wi2 2 (ei )
i=1
University of Melbourne FBE
Index Models
24
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
A / 2 (eA )
2
E (RM )/M
N
X
wi i
i=1
wA0
1 + (1 A )wA0
Index Models
25
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
wM
= 1 wA
9. Calculate the risk premium of the optimal risky portfolio from the risk premium of
the index portfolio and the alpha of the active portfolio
E (RP ) = (wM
+ wA A )E (RM ) + wA A
10. Compute the variance of the optimal risk portfolio from the variance of the index
portfolio and the residual variance of the active portfolio
2
P2 = (wM
+ wA A )2 M
+ (wA (eA ))2
Index Models
26
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Expected Return
0.30
0.25
0.12
0.25
Beta
1.9
1.2
1.6
0.7
Residual SD
0.45
0.49
0.38
0.22
Suppose that the risk-free rate is 4% and a passive equity portfolio (an index
portfolio) has a 15% expected return with a 15% standard deviation
Optimal risky portfolio?
Index Models
27
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Example (contd)
So
A
B
C
D
Index Models
28
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Example (contd)
Step 1
wi0
i
2 (ei )
0.2519
0.3249
-0.6648
2.7479
2.6598
Step 2
wi =
w0
PN i
i=1
wi0
0.0947
0.1221
-0.2499
1.0331
1.0000
Index Models
29
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Example (contd)
Index Models
30
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Example (contd)
A / 2 (eA )
0.1758/0.0661
=
= 0.5441
2
(0.15 0.04)/0.0225
E (RM )/M
N
X
wi i
i=1
Index Models
31
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Example (contd)
wA0
0.5441
= 0.4570
=
1 + (1 0.6497)(0.5441)
1 + (1 A )wA0
Step 8: Find the weights of the active portfolio and the index portfolio in the
optimal risky portfolio
wM
= 1 wA = 1 0.4570 = 0.5430
Index Models
32
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Example (contd)
E (RP ) =(wM
+ wA A )E (RM ) + wA A
2
P2 =(wM
+ wA A )2 M
+ (wA (eA ))2
0.0661)2 = 0.0297
0.1727
0.0297
= 1.0021
SM =
Index Models
0.11
0.0225
= 0.7333
33
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Portfolio of 6 stocks (+ the market portfolio): H-P, Dell, Target, Wal-Mart, BP,
and Shell
For each stock, we can get estimates of betas i and residual variances 2 (ei )
from estimating their SCL:
Obtain 60 monthly observations of rates of return for each stock and the S&P 500
index
Compute the excess returns (over T-bills) on the 7 components of the portfolio
For each individual stock (e.g., HP), estimate the regression equation:
RHP (t) = HP + HP RM (t) + eHP (t)
Index Models
34
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Index Models
35
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
alpha
Beta
17
2
2
HP
m
2
P
R2 =
2
2
HP
m
2
P
=1
2 (eHP )
2
P
2 =
m
P2 =
2
R P
2
HP
2 (eHP )
1R 2
.52390.0124
2.03482
.0059
1.5239
= 0.0124
= 0.0016
Index Models
36
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
Thus, the optimal portfolio derived from the single-index model might be inferior
to the one obtained from the Markowitz model
Index Models
37
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Active Management
Implementation
Comparison with Markowitz
For our 6-stock portfolio, the difference between the two approaches is negligible:
Index Models
38
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Index Models
39
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Index Models
40
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Note: the CAPM is derived using expected returns, which are not observed
Index Models
41
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Estimating the SCL gets us alpha and beta estimates for a given stock.
It is true that if CAPM holds, we should find an alpha estimate of zero (and
practically speaking, a beta estimate between 0.5 and 2.0).
We could take these betas for a number of assets or portfolios, and use them as
x-variables in a cross-sectional test of CAPM:
rit rf = a + b i + it .
Does it work?
Index Models
42
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
14
10
2
0.0
0.2
0.4
0.6
0.8
betas
1.0
1.2
1.4
Index Models
43
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Index Models
44
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
The proxies for the market portfolio do not fully capture all of the relevant risk
factors in the economy
For example, human capital is excluded from the various proxies (ASX200) for the
market portfolio
E.g., large firms may be perceived to be less vulnerable to economic downturns that
diminish the value of human capital lower risk-premium
There may be behavioral biases against classes of stocks, which have nothing to
do with the reward-to-risk ratios on stocks
E.g., portfolio managers dont lose their jobs for investing in BHP
...but they may if they invest in a financially distressed company when it is selling
for $0.10/share
University of Melbourne FBE
Index Models
45
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Potential Remedies
Index Models
46
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Takeaways
Optimal active portfolios constructed from the index model include analysed
securities in proportion to their information ratios.
The empirical failure of the CAPM suggests that more than one risk factor are
necessary to explain the cross-section of stock returns.
To be continued next seminar...
Index Models
47
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Additional Resources
Plenty of online resources for you to explore valuation and portfolio selection
issues:
Value Line Investment survey: popular source of finding a stocks beta, but also
investment-related articles
http://www.valueline.com/
William Sharpes website: the 1990 Nobel prize in Economics winner has plenty of
articles on asset valuation and allocation, applications to retirement saving, etc.
http://www.wsharpe.com/
http://www.moneychimp.com/: informative education site on investments that
includes CAPM calculators for estimating a stocks return and a market simulator
Index Models
48
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Appendix
Index Models
49
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Size Effect A number of researchers, starting with Keim (1981) and Banz
To get aInhandle
onminimize
this effect,
we can builderror,
portfolios
sorted
past market
order to
measurement
we will
formon
portfolios
of
capitalizations.
stocks based on their past market capitalizations
Dec
MKCap(m$)
NYSE
10
9
8
7
6
5
4
3
2
1
511,391
10,486
4,428
2,237
1,387
889
534
353
198
95
172
172
172
172
172
172
172
172
172
172
FIN460-Papanikolaou
# of Stocks
AMEX
NASDAQ
5
3
5
5
5
11
15
32
73
412
80
81
136
166
217
254
251
400
551
1,399
Index Models
Total
257
256
313
343
394
437
438
604
796
1,983
14/ 37
50
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
14
12
10
0
1
10
MKCAP Decile
15/ 37
51
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Size Effect To
- Size
Sorts
resolve this, Fama and French (1992) do a double sort, first on
size, then on market b.
Fama & French (1992) do a double sort, first on size and then on market .
1/Size ("Smallness")
Market Beta
Index Models
52
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Fama & French (1992) find that the relation between average returns and within a
size decile is generally negative.
Index Models
53
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Index Models
54
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
Suppose
weEffect
sort all stocks into 10 portfolios based on the ratio of the book value
The
Value
of equity to the market value of equity with rebalancing occurring yearly.
Here Puzzle
are the
characteristics
portfolios
is more
pronouncedof
in these
the post-war
periodin the post-war era:
Sort
Lo
3.95
(2.67)
18.01
2
5.59
(2.42)
16.35
a
(t)
bMKT
(t)
R2 (%)
-2.07
(1.05)
1.10
(0.02)
86.02
-0.04
(0.73)
1.03
(0.02)
91.34
E(Ri )
rf
0.95
(0.95)
0.97
(0.03)
85.63
1.38
(1.01)
0.89
(0.03)
81.92
2.38
(0.92)
0.90
(0.03)
83.31
3.63
(1.10)
0.86
(0.03)
76.58
Index Models
4.05
(1.12)
0.84
(0.03)
75.20
9
9.64
(2.37)
16.01
Hi
11.11
(2.73)
18.46
Hi-Lo
7.16
(2.28)
15.39
4.66
(1.23)
0.91
(0.04)
74.27
5.71
(1.71)
0.99
(0.05)
65.82
7.78
(2.44)
-0.11
(0.06)
1.07
55
Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
16
14
12
Large Value
10
8
Large Growth
6
Small Growth
4
2
0.7
0.8
0.9
1.1
1.2
1.3
1.4
1.5
1.6
Market beta
FIN460-Papanikolaou
Index Models
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Intro
Single Index Model
Diversification
Index Models in Practice
Empirical Validity of the Index Model
Conclusions
The
MomentumMomentum
Effect
Short-Term
Jagadeesh & Titman (1993) showed that firms with high (low) returns in the
previous
tendoftostocks
haveselected
high (low)
returns
in the
following
few
months.
Form year
portfolios
on their
past return
over
the last 12
months.
will rebalance these portfolios every month.
FormWeportfolios
based on past performance over the last 12 months with monthly
rebalancing.
Lo
0.31
(3.70)
33.24
Wi
15.37
(2.52)
22.64
Wi-Lo
15.07
(2.94)
26.44
a
(t)
bMKT
(t)
R2 (%)
-11.52
(1.65)
1.53
(0.08)
74.95
-5.08
(1.31)
1.33
(0.07)
78.61
7.48
(1.33)
1.02
(0.06)
71.90
19.01
(2.44)
-0.51
(0.13)
13.05
Sort
E(Ri )
rf
-3.91
(1.12)
1.17
(0.06)
82.24
-1.77
(0.94)
1.10
(0.04)
85.01
-1.18
(0.79)
1.03
(0.04)
87.30
-0.39
(0.66)
1.03
(0.02)
90.93
1.09
(0.70)
0.98
(0.02)
89.64
3.05
(0.70)
0.94
(0.02)
88.34
3.97
(0.81)
0.97
(0.03)
85.09
Again, this is quite inconsistent with the CAPM. Momentum seems to also exist in
many different assets classes such as commodities and currencies.
University of Melbourne FBE
Index Models
57