FMT – IPM

Lecture 5:
Chapter 8: SINGLE INDEX MODEL
Chapter 9: CAPITAL ASSET PRICING
MODEL

Ms. Phuong Pham, MSc

Lecture outline
• Advantages of a single-factor model
• Risk decomposition
• Systematic vs. firm-specific
• Single-index model and its estimation
• Optimal risky portfolio in the index model
• Index model vs. Markowitz procedure
1 SINGLE FACTOR
MODEL
 Single index model

• Advantages
• Reduces the number of inputs for
diversification
• Easier for security analysts to specialize
• Model ri = E (ri ) + bi m + ei
• βi = response of an individual security’s return
to the common factor, m; measure of
systematic risk
• m = a common macroeconomic factor
• ei = firm-specific surprises
 Single-Index Model

• Regression equation:
Ri (t ) = a i + bi RM (t ) + ei (t )
excess return (Rt) = r - rf

• Expected return-beta relationship:

E (Ri ) = a i + bi E (RM )

•
 Single-Index Model
• Variance = Systematic risk + Firm-specific risk:

s = b s + s (ei )
i
2
i
2 2
M
2

• Covariance = Product of betas × Market index risk:

Cov ( ri , rj ) = bi b js 2
M

• Correlation = Product of correlations with the market index

bi b js M2 bis M2 b js M2
Corr ( ri , rj ) = =
s is j s is M s js M
= Corr ( ri , rM ) ´ Corr ( rj , rM )
 Index Model and
Diversification
• Variance of the equally-weighted portfolio of
firm-specific components:
2

s (e p ) = å ç ÷ s (ei ) = s (e )
2
n
æ1ö 2 1 2
i =1 è n ø n
• When n gets large, σ2(ep) becomes negligible
and firm specific risk is diversified away
Excess Returns on Figure 8.2
HP and S&P 500
 Scatter Diagram of HP, the Figure 8.3
S&P 500, and HP’s SCL

SCL

RHP (t ) = a HP + b HP RS &P500 (t ) + eHP (t )

Output: Regression Statistics
for the SCL of HP
 Interpreting the Output

• Correlation of HP with the S&P 500 is 0.7238

• The model explains about 52% of the
variation in HP
• HP’s alpha is 0.86% per month (10.32%
annually) but it is not statistically significant
• HP’s beta is 2.0348, but the 95% confidence
interval is 1.43 to 2.53
2 Capital Asset Pricing
Model
 Capital Asset Pricing Model
(CAPM)

• It is the equilibrium model that underlies all

modern financial theory
• Derived using principles of diversification with
simplified assumptions
• Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development
 Assumptions

• Investors optimize portfolios a la Markowitz

• Investors use identical input list for efficient
frontier
• Same risk-free rate, tangent CAL and risky
portfolio
• Market portfolio is aggregation of all risky
portfolios and has same weights
 CAPM

[
E (rGE ) = rf + b GE E (rM ) - rf ]
• CAPM holds for the overall portfolio because:
E ( rP ) = å wk E ( rk ) and
k

b P = å wk b k
k
• This also holds for the market portfolio:
E ( rM ) = r f + b M éë E ( rM ) - r f ùû
The Security Market Line Figure 9.2
The SML and a Positive-
Alpha Stock