Lecture 4 Index Models

4.1 Markowitz Portfolio Selection Model

Markowitz’s Portfolio Selection Model
• Formation of risky portfolio based on
– Expected return.
– Risk
• Portfolio risk is a function of
– The weight in which each asset is held.
– The covariance of the returns on pairs of assets forming part of the
portfolio.
• The method we use to identify the efficient set of portfolios is known
as the Markowitz Portfolio Selection Model.

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Markowitz Portfolio Selection Model
• Computationally intensive
– Even if
▷ Only a relatively small numbers of assets are involved
▷ The process is automated.
– Reason:
▷ Estimating n expected returns.
▷ Estimating n variances.
▷ Estimating (n2 − n)/2 covariances.
• Example.
– 10 stocks?
– 50 stocks?
– 100 stocks?

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Markowitz Portfolio Selection Model

• By stipulating the manner in which security returns are generated, we

can
– Simplify how we describe sources of risk.
– Reduce the computational effort associated with Markowitz’s model.
• Question: How do we do this?
– Single factor models of risk and return such as index models.
– The Capital Asset Pricing Model (CAPM).
– Arbitrage pricing and multi-factor pricing models.

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 4.2 A Single-Factor Security Market
A Single-Factor Security Market
• Advantages
– Reduces the number of inputs for diversification.
– Easier for security analysts to specialize.
• Model
ri = E(ri) + ei
– ri: Rate of return on security i.
– E(ri): Expected component.
– ei: Unexpected component.
• We know from previous lecture
– The covariances between security returns tend to be positive.
– This stems from economic factors having common influences on
asset prices.
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A Single-Factor Security Market

• We can further decompose the unexpected component of returns on

security i.
• Model
ri = E(ri) + m + ei
– m: a common macroeconomic factor.
– ei: firm-specific surprises.
• The expected value of both m and ei are zero and the two are uncor-
related.

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 A Single-Factor Security Market

• Decompose the variance

σi2 = σm
2
+ σ 2(ei)
• The covariance between the returns on securities i and j is
2
Cov(ri, rj ) = Cov(m + ei, m + ej ) = σm
• If assets have different sensitivities βi to the macro factor
ri = E(ri) + βim + ei
– Variance
σi2 = βi2σm
2
+ σ 2(ei)
– Covariance
2
Cov(ri, rj ) = Cov(βim + ei, βj m + ej ) = βiβj σm

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The Single-Index Model
• How we measure the unexpected macro factor m?
– Use return on a broad index of securities M as a proxy.
– ASX All Ordinaries Index (Australia).
– S&P 500 index (US).
• Such a model is called the Single-Index model.
• Formally
Rit = αi + βiRM t + eit
– αi: The security’s excess return when the market’s excess return is
zero.
– βi: The security’s sensitivity to the index.
– ei: The residual, or the unexpected firm-specific component of the
return.

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The Single-Index Model

• Expected return-beta relationship.

E(Ri) = αi + βiRM
– Variance = Systematic risk + Firm-specific risk
σi2 = βi2σM
2
+ σ 2(ei)
– Covariance = Product of betas × Market index risk
2
Cov(ri, rj ) = βiβj σM
– Correlation = Product of correlations with the market index
2
βiβj σM 2 β σ2
βiσM j M
Corr(ri, rj ) = = = Corr(ri, rM )Corr(rj , rM )
σiσj σiσM σj σM

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Concept Check 8.1
The data below describe a three-stock financial market that satisfies
the single-index model.
Stock Capitalization Beta Mean Excess Return Std. Dev.
A $3000 1.0 10% 40%
B $1940 0.2 2% 30%
C $1360 1.7 17% 50%

The standard deviation of the market-index portfolio is 25%.

a. What is the mean excess return of the index portfolio?
b. What is the covariance between stock A and stock B?
c. What is the covariance between stock B and the index?
d. Break down the variance of stock B into its systematic and firm-
specific components.

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Concept Check 8.1
The data below describe a three-stock financial market that satisfies
the single-index model.
Stock Capitalization Beta Mean Excess Return Std. Dev.
A $3000 1.0 10% 40%
B $1940 0.2 2% 30%
C $1360 1.7 17% 50%

The standard deviation of the market-index portfolio is 25%.

a. What is the mean excess return of the index portfolio?
Solution:
Total market capitalization is 3000 + 1940 + 1360 = 6300. The mean
excess return of the index portfolio is
3000 1940 1360
× 10 + ×2+ × 17 = 9.05%
6300 6300 6300

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Concept Check 8.1
The data below describe a three-stock financial market that satisfies
the single-index model.
Stock Capitalization Beta Mean Excess Return Std. Dev.
A $3000 1.0 10% 40%
B $1940 0.2 2% 30%
C $1360 1.7 17% 50%

The standard deviation of the market-index portfolio is 25%.

b. What is the covariance between stock A and stock B ?
Solution:
The covariance between stocks A and B equals
2
Cov(RA, RB ) = βAβB σM = 1 × 0.2 × 0.252 = 0.125

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Concept Check 8.1
The data below describe a three-stock financial market that satisfies
the single-index model.
Stock Capitalization Beta Mean Excess Return Std. Dev.
A $3000 1.0 10% 40%
B $1940 0.2 2% 30%
C $1360 1.7 17% 50%

The standard deviation of the market-index portfolio is 25%.

c. What is the covariance between stock B and the index?
Solution:
The covariance between stock B and the index portfolio equals
2
Cov(RB , RM ) = βB σM = 0.2 × 0.252 = 0.125

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Concept Check 8.1
The data below describe a three-stock financial market that satisfies
the single-index model.
Stock Capitalization Beta Mean Excess Return Std. Dev.
A $3000 1.0 10% 40%
B $1940 0.2 2% 30%
C $1360 1.7 17% 50%

The standard deviation of the market-index portfolio is 25%.

d. Break down the variance of stock B into its systematic and firm-
specific components.
Solution:
The total variance of B equals
2 2 2
σB = V ar(βB RM + eB ) = βB σM + σ 2(eB )
2 σ 2 = 0.22 × 0.252 = 0.0025. Thus the firm-
Systematic risk equals βB M

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specific variance of B equals
σ 2(eB ) = σB
2
− βB σM = 0.302 − 0.22 × 0.252 = 0.0875
2 2

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 Concept Check 8.1
Suppose that the index model for the excess return of stocks A and B
is estimated with the following results
RA = 1.0% + 0.9RM + eA
RB = −2.0% + 1.1RM + eB
σM = 20%
σ(eA) = 30%
σ(eB ) = 10%
Find the standard deviation of each stock and the covariance between
them.
Solution:
The variance of each stock is β 2σM
2 + σ 2(e).

For stock A, we have

2
σA = 0.92 × 0.22 + 0.32 = 0.1224, σA = 0.35
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For stock B, we have
2
σB = 1.12 × 0.22 + 0.12 = 0.0584, σA = 0.24
The covariance is
2
βAβB σM = 0.9 × 1.1 × 0.22 = 0.0369

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 Advantages of The Single-Index Model
• What we need? Suppose there are n securities.
– n estimates of expected excess returns, E(Ri).
– n estimates of sensitivity coefficients βi.
– n estimates of the firm-specific variances σ 2(ei).
– 1 estimates for the common macroeconomic factor σM
2 .

• In total 3 × n + 1.
• Remember in the Markowitz Portfolio Selection we need 0.5 × n2 +
1.5 × n.
• The single-index model provides further insight by recognizing that
different firms have different sensitivities to macroeconomic events.
• The model also summarizes the distinction between macroeconomic
and firm-specific risk factors.

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The Index Model and Diversification
• Portfolio
Rp = αp + βpRM + ep
• The number of stocks included in the portfolio increases, the part of the
portfolio risk attributable to non-market factors becomes ever smaller.
• Market risk remains, regardless of the number of firms combined into
the portfolio.
Xn X
n
Rp = ωi R i = ωi(αi + βiRM + ei)
i=1 i=1
Xn Xn X
n
= ωi α i + ( ωiβi)RM + ωiei
i=1 i i=1
Xn
1 2
2
σ (ep) = ωi2σ 2(ei) |{z}
= σ̄ (e)
When ω = 1/n
n
i=1 i

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The Index Model and Diversification

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Estimating the Single-Index Model

• Using historical data to estimate the single-index model yields the Se-
curity Characteristic Line (SCL).
• Formally, we regress the monthly excess return for firm i against the
monthly excess return on a broad index.
Ri,t = α + βRM,t + ei,t
– α: The intercept is the asset’s alpha for the sample period.
– β : The slope represents the beta of the asset.
– ei,t: The error terms represent the difference between actual returns
and those predicted by the regression line, or the unexpected firm-
specific component of the return.

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Estimating the Single-Index Model

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Estimating the Single-Index Model

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Estimating the Single-Index Model

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Estimating the Single-Index Model

• Preparing data
Return − Risk-free rate → Excess Return
• Regression
Rit = α + βRM t + ϵit
– Ordinary Least Squares
PT
i=1(RM t − R̄M t)(Rit − R̄it)
β= PT
i=1(RM t − R̄M t)
2

α = R̄it − β R̄M t
• Excel example

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The Single-Index Model

• Yields a value of beta.

– Helpful in estimating future systematic risk.
• Yields a value of alpha.
– Not use it as a forecast for future alpha.
▷ Evidence suggests that estimates from successive periods are es-
sentially uncorrelated.
▷ Analysts must use security analysis to develop their expectation
regarding future alpha.

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The Single-Index Model

• Security analysis yield a list of alpha values

• Form part of the asset’s overall expected return.
• These values suggest whether securities are good deals.
– Positive alpha securities provide returns above what they should
given their market risk (i.e. they are underpriced), so should be
overweighted relative to the market portfolio.
– The reverse is true for negative alpha securities.
• However, by deviating from the market portfolio, we introduce unsys-
tematic risk.

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 4.3 Portfolio Construction and the Single-Index Model
Portfolio Construction and the Single-Index Model
• We use alpha, beta, and risk and return estimates for the market index
to generate efficient frontier.
– Alpha, beta and index risk premium estimates can be used to gen-
erate expected returns.
E(Ri) = αi + βiE(RM )
– Beta, residual variance and index variance estimates can be used to
construct the covariance matrix by recalling.
σi2 = βi2σM2
+ σ 2(ei)
2
Cov(ri, rj ) = βiβj σM
– We can then identify the optimal risky portfolio by maximizing the
Sharpe ratio whilst ensuring weights held in all risky assets sum to
1.
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Portfolio Construction and the Single-Index Model

• Specifically
∑
n ∑
n
E(Rp) = αp + E(RM )βp = ωiαi + E(RM ) ωiβi
i i=1
 ( n )2 1
2
∑ ∑
n
+ σ (ep)] = σM ωi2σ 2(ei)
1
σp = [βp2σM
2 2 2 2
ωiβi +
i=1 i=1

Sp =
E(Rp)
σp

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The Optimal Risky Portfolio and the Single-Index Model

• When returns follow the index model, we can directly solve for the
optimal risky portfolio.
• To do this, we must view the portfolio as a combination of
– An active portfolio, A, comprising the n analyzed securities with
significant alphas in some weight.
– The market-index portfolio, M, which is a passive portfolio.

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The Optimal Risky Portfolio and the Single-Index Model
• The weight in which the active portfolio will be held in the optimal
risky portfolio will
– Reflect both its contribution to the optimal risky portfolio (i.e. via
its alpha).
– Also take into account how it contributes to the risk of the optimal
risky portfolio (i.e. via its residual variance).
• The Sharpe ratio of an optimally constructed risky portfolio will be
greater than that enjoyed by the index (passive portfolio).
[ ]2
2 2 αA
Sp = SM +
σ(eA)
– The extra return provided by security analysis will be captured by
the information ratio.

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 Summary of Optimization Procedure
1. Compute the initial position of each security as ωi0 = αi/σ 2(ei).
2. Scale those initial positions so that
ωi0
ωi = ∑n 0
ω
i=1 i
∑n
3. Compute the alpha of the portfolio as αA = i=1 ωiαi.
∑n
4. Compute the residual variance as σ 2(eA) = ω
i=1 i
2σ 2(e ).
i

5. Compute the initial position in the portfolio

α /σ 2(e )
0 A A
ωA = .
E(RM )/σM 2
∑n
6. Compute the beta of the portfolio as βA = i=1 ωiβi.
0
ωA
7. Adjust the initial position in the portfolio by ωA = 0.
1+(1−βA)ωA

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 Summary of Optimization Procedure

∗ = 1 − ω ∗ and ω ∗ =
7. The optimal risky portfolio now has weights ωM A i
∗ω .
ωA i

8. The risk premium is

E(Rp) = (ωM∗ + ωA∗ βA)E(RM ) + ωA∗ αA.
9. The variance of the optimal risky portfolio is
∗ ∗ ∗
σp2 = (ωM + ωA βA)2σM
2
+ (ωA σ(eA))2

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The Index Model in Practice

• The index model has become a benchmark used by practitioners.

• However, practitioners often estimate the model using total rather than
excess returns.
• This changes their estimate of αi to αi + rf (1 − βi).
ri = rf + αi + βi(rM − rf ) + ei
= rf + αi + βirM − βirf + ei
= αi + rf (1 − βi) + βirM + ei
• The slope coefficient should remain unchanged if rf does not vary
over time.

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The Index Model in Practice
• It is also important to recognise that
– Betas tend towards one over time.
– This trend suggests betas estimated using historical data may not
provide the best estimate of future betas.
– Therefore, it may be necessary to forecast betas in some manner.
• Empirical studies offer some guidance on useful predictors of betas.
– Variance of earnings and cash flows.
– Growth in EPS.
– Firm size.
– Dividend yield.
– Firm leverage, as measured by the ratio of debt to assets.
– Industry in which the firm operates.

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