Index Models: Objectives

• Reduces the number of inputs for diversification.

• Make it easier to estimate Variance Covariance
Matric (VCM).
• Have implication for security analysis, Macro-
Risk vs. Micro-Risk , common bench marks and
specializations for security analysis.
• Optimization through limited number of
estimates. Its advantages and disadvantages.

8-1
 Single Factor Model
ri  E ( ri )   i m  e i
ßi = Sensitivity of the security towards an index, it
gauges the tendency of increase/decrease in
returns of the security, given 1%
increase/decrease in m.
m = Unanticipated market related shocks to which
security returns respond, one proxy of an index is
market returns, like S&P-500 and KSE-100.
ei = It is firm specific effect and is uncorrelated
with the index m.

8-2
 Single-Index Model Continued

• Risk and covariance:

– Total risk = Systematic risk + Firm-specific
risk:  i2   i 2  M2   2 ( e i )
– Covariance = product of betas x market index
risk:
C o v ( r i , r j )   i  j  M2

– Correlation = product of correlations with the

market index
 i  j  M2  i  M2  j  M2
C o r r ( ri , r j )    C o r r ( ri , r M ) x C o r r ( r j , r M )
 i j  i M  j  M

8-3
 Single-Index Model

• Regression Equation:
R t(t)   i   t R M (t)  ei(t)
• Expected return-beta relationship:

E (R i)   i   iE (R M )

8-4
Concept Check.

8-5
The Set of Estimates Needed for Single-Index Model.

8-6
 Some Benefits of Index Model
• Specialization in securities analysis, industry
specialist.
• The performance of an security analyst, given
same benchmark.
• The cost of oversimplification.
– Industry events, should we count or not.
• Residual correlation positive and negative.
– How Markowitz optimization may have
advantage over index optimization.

8-7
Concept Check 2

8-8
 Index Model and Diversification
• Portfolio’s variance:

 2
P   
P
2 2
M   (eP )
2

• Variance of the equally weighted portfolio

of firm-specific components:
2
n
1 2 1 2
 ( e P )      ( ei )   ( e )
2

i 1  n  n

• When n gets large,  2 ( e P ) becomes

negligible
8-9
Figure 8.1 The Variance of an Equally
Weighted Portfolio with Risk Coefficient
βp in the Single-Factor Economy

8-10
Concept Check 3

8-11
Figure 8.2 Excess Returns on HP and
S&P 500 April 2001 – March 2006

8-13
Figure 8.4 Excess Returns on Portfolio
Assets

8-14
 Figure 8.3 Scatter Diagram of HP, the
S&P 500, and the Security Characteristic
Line (SCL) for HP

8-15
 Table 8.1 Excel Output: Regression
Statistics for the SCL of Hewlett-Packard

8-16
Returns on Ghazi Tractor and KSE 2012-2016

Excess Returns
0.5

0.4

0.3

0.2

0.1

-0.1

-0.2

-0.3
12/23/2011 5/6/2013 9/18/2014 1/31/2016 6/14/2017

Al-Ghazi Tractors KSE

8-17
 Scatter Diagram for expected returns and
realized returns for Ghazi Tractor 2012-2016
KSE Line Fit Plot
0.5

0.4
Al-Ghazi Tractors

0.3

0.2

0.1

0
-0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25

-0.1

-0.2

-0.3
Predicted Al-Ghazi Tractors Al-Ghazi Tractors

8-18
Excel Out-Put for Ghazi Tractor 2012-2016

8-19
8-20
8-21
8-22
 Alpha and Security Analysis

• Macroeconomic analysis is used to estimate

the risk premium and risk of the market index
• Statistical analysis is used to estimate the
beta coefficients of all securities and their
residual variances, σ2 ( e i )
• Developed from security analysis

8-27
Alpha and Security Analysis Continued
• The market-driven expected return is
conditional on information common to all
securities
• Security-specific expected return forecasts are
derived from various security-valuation models
– The alpha value distills the incremental risk
premium attributable to private information
• Helps determine whether security is a good or
bad buy

8-28
 Single-Index Model Input List

• Risk premium on the S&P 500 portfolio

• Estimate of the SD of the S&P 500 portfolio
• n sets of estimates of
– Beta coefficient
– Stock residual variances
– Alpha values

8-29
Optimal Risky Portfolio of the Single-
Index Model
• Maximize the Sharpe ratio
– Expected return, SD, and Sharpe ratio:
n 1 n 1
E ( RP )   P  E ( RM )  P   wi i  E ( RM )  wi  i
i 1 i 1
1
1  2 
n 1 2
 n 1 2 2  2
 P    P M   ( eP )    M   wi  i    wi  ( ei ) 
2 2 2 2

  i 1  i 1 
E ( RP )
SP 
P

8-30
 Procedure
• We have given 6 stocks from the US markets
and we have following information.

• Now using random weights from 1 to 7, the

expected return is =1.6128 and SD=4.0621.
This gives the Sharpe ratio of = 0.3970.

8-31
 Procedure

ER 0.0648 ER (S&P-500) 0.06

SD 0.1422 SD (S&P-500) 0.1358
SR 0.4556 SR (S&P-500) 0.442

8-32
 Figure 8.5 Efficient Frontiers with the
Index Model and Full-Covariance Matrix

8-33
Table 8.2 Comparison of Portfolios from
the Single-Index and Full-Covariance
Models

8-34
Optimal Risky Portfolio of the Single-Index Model
Continued

8-35
Optimal Risky Portfolio of the Single-
Index Model Continued
– Modification of active portfolio position:
0
w
w  *
A
A
1  (1   A ) w A
0

– When

 A  1, w *
A  w 0
A

8-36
 The Information Ratio

• The Sharpe ratio of an optimally constructed

risky portfolio will exceed that of the index
portfolio (the passive strategy):
2
2 2  A 
sP  s M

  ( e )
A 


8-37