Lecture 6

1. Non-diversifiable and Diversifiable risk 2.
Index model
Investments and Portfolio Analysis

Lecture 6: Index Models
Ref. Chapters 7 and 8
Dr. Maxime Couvert
University of Hong Kong
Fall, 2023
Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 1 / 49

Today’s agenda
1. Non-diversifiable and Diversifiable risk

1.1 Variance of a portfolio’s returns
1.2 A model approach
2. Index model
2.1 The market index model
2.2 Alpha and beta
Part 1. Non-diversifiable and Diversifiable risk
Part 1.1. Variance of a portfolio’s returns
1. Non-diversifiable and Diversifiable risk 2. Index model
Part 1.1. Variance of a portfolio’s return

For a portfolio p made up of N risky securities, the rate of return is:
N
X
Rp = ωi Ri
i=1
where ωi is the weight in asset i ( N

P
i=1 ωi = 1)
The variance of portfolio p’s return is given by
N X
X N
σp2 = ωi ωj Cov (Ri , Rj )
i=1 j=1
as Cov (Ri , Ri ) = σp2 , the variance can be expressed as:

N
X N
X N
X
σp2 = ωi2 σi2 + ωi ωj Cov (Ri , Rj )
i=1 i=1 j=1,j̸=i
If ωi ’s have comparable magnitudes across securities ⇒ N, variance

terms become unimportant relative to N(N − 1)
Part 1.1. Diversification - a simplified setting

1
If we simplify to the case where ωi = N for all stocks, then the
portfolio variance can be rewritten as
N 2 N N 2
X 1 X X 1
σp2 = σi2 + Cov (Ri , Rj )
N N
i=1 i=1 j=1,j̸=i
 
N N N
!
1 1 X 2 N −1 1 X X
= σi + Cov (Ri , Rj )
N N N N(N − 1)
i=1 i=1 j=1,j̸=i
1 2 N −1
= σ + Cov (Ri , Rj )
N i N
A N grows large,
σp2 −→ Cov (Ri , Rj )

Part 1.1. Diversification speed
If we further simplify to the case by assuming that all stocks have the
same variance and all the pairwise covariances are equal
▶ σi = σj = σ for all i and j
▶ Cov (Ri , Rj ) = cov for all (i, j)
Cov (Ri ,Rj ) cov
▶ ⇒ pairwise correlation is also the same σi σj = σ2
We can then simplify the previous equation further:
1 2 N −1
σp2 = σ + cov
N N
σp2 1 N − 1 cov
= +
σ2 N N σ2
σp2 cov
As N grows big, σ2
→ σ2
= Corr (Ri , Rj ), for any pair (i, j)

Part 1.1. Diversification speed (continue)
With Corr (Ri , Rj ) = 0.3, for any pair (i, j)

σp2
N σi2
1 1.00
2 0.65
5 0.44
15 0.35
30 0.32
∞ 0.30
Diversification effect occurs pretty quickly (with 30 stocks the

portfolio variance has been reduced to a level close to the limiting
case)

Part 1.1. Benefits of diversification

Part 1.1. Portfolio risk vs. the number of stocks

Part 1.1. Computational challenge
To calculate the portfolio variance, even in the limiting case, one

needs to calculate N(N−1)
2 covariance terms.
▶ If we have 2000 stocks, that’s 2 million covariances to calculate
Too many covariances and variances to estimates

Because each estimate has estimate error ...
▶ We use sample covariances to estimate true covariances
▶ We use sample variances to estimate true variances
Estimation errors can accumulate 2 million times and possibly causing

big errors in selection choices
Ways simplify the estimation process (to make fewer estimations) are
desired

Part 1. Non-diversifiable and Diversifiable risk
Part 1.2. A model approach
Part 1.2. Single index model
Assume:
There exists a single macro factor that:
▶ Summarizes all relevant macro condition
▶ Moves the market as a whole
▶ Is the only source of returns correlation
All other risk in a stock is idiosyncratic (or firm-specific)

▶ No firm affects any other firm’s returns

Part 1.2. One common source of risk

Part 1.2. What do the assumptions mean?
Imagine, your favorite stock goes up 10%. Why? This realized return has
three components:
1 The fair expected return for that stock, foreseeable level ex-ante
2 News about in the market as a whole, and
3 News affect this stock alone
News cannot be anticipated a priori

Part 1.2. Returns structure
More formally, we can state these elements as:
Ri = E0 [Ri ] + mi + ei
1 Ri ≡ Security i’s return

2 E0 [Ri ] ≡ Expected return for security i
3 mi ≡ Unexpected market news
4 ei ≡ Unexpected firm news

Part 1.2. The level of risk
Stock i ’s total risk = Systematic risk + Firm-specific risk
Var (Ri ) = Var (mi ) + Var (ei )
Recall mi is driven by the common macro conditions

mi is the only reason for non-zero correlation between two stocks:
▶ Formally, Corr (mi , mj ) ̸= 0
▶ Normally, Corr (mi , mj ) > 0, because the macro conditions likely affect
all stocks in the same direction
ei is specific to stock i:
▶ Formally, Corr (ei , ej ) = 0 for any stock j other than i
Cov (mi , ei ) = 0

Part 2. Index model
Part 2.1. Characteristic lines and portfolios
Part 2.1. Market index model
mi is too abstract
Economists want more structure to formulate the index model:
▶ The market index: used to capture the macro condition, or the
common source of risk, MKT
▶ Beta representation: used to express mi in a linear way, βi MKT

mi is too abstract
Formally,
▶ Rie : stock i’s excess return
e
▶ Rm : market index (portfolio)’s excess return
▶ The market index model formula of Rie is:
Rie = αi + βi Rm
e
+ ϵi


mi is too abstract
Formally,
▶ Rie : stock i’s excess return
e
▶ Rm : market index (portfolio)’s excess return
▶ The market index model formula of Rie is:
Rie = αi + βi Rm
e
+ ϵi
Comparing terms:
e
E [Ri ] ≡ Rf + αi + βi E [Rm ]
e e
mi ≡ βi (Rm − E [Rm ])
ei ≡ ϵi
Part 2.1. Market and Non-Market Returns
Return decomposition:
e
▶ βi R m : market-related return
▶ ϵi : non-market related return
▶ αi : part of expected return
αi = E [Rie ] − βi E [Rm
e
]
Random: Rie , Rm
e , ϵ ; constant: α , β
i i i
By construction,
e
Cov (ϵi , Rm ) = 0 and E [ϵi ] = 0

Part 2.1. The variance matrix
Now, variance-covariance matrix becomes much simpler
Now, the calculation of covariance can be simplified:
Cov (Rie , Rje ) = βi βj Var (Rm

e
)
e ) to estimate
Now, you only need to estimate N βi s and 1 Var (Rm,t
the pairwise covariances.
When N = 2000, we need to estimate 2001 betas << 2 million
covariances

Part 2.1. Combining assets - A general case
Consider a portfolio p of N assets, 1,2,... and N,

N
X
Rpe = ωi Rie
i=1
Rie e
= αi + βi Rm + ϵi
e can also be expressed as α + β R e + ϵ
We can know, Rp,t p p m p
PN
αp = i=1 ωi αi
PN
βp = i=1 ωi βi
PN
ϵp = i=1 ωi ϵi

Part 2.1. Exercise

The following are estimates for two stocks
Stock Expected return Beta Standard deviation

A 13% 0.8 30%
B 18% 1.2 40%
The market index has a standard deviations of 22% and the risk-free rate
is 8%. Suppose that we were to construct a portfolio with proportions:
A 30%
B 45%
T-bill 25%
Calculate for this portfolio:

Expected return?

Part 2.1. Exercise


A 13% 0.8 30%
B 18% 1.2 40%
A 30%
B 45%
T-bill 25%
Expected return:
E [Rp ]= ωA × E [RA ] + ωB × E [RB ] + ωf × E [Rf ]
= 0.3 × 13% + 0.45 × 18% + 0.25 × 8% = 14%
Part 2.1. Exercise


A 13% 0.8 30%
B 18% 1.2 40%
A 30%
B 45%
T-bill 25%

Standard deviation?

Part 2.1. Exercise

A 13% 0.8 30%
B 18% 1.2 40%
ωA = 30%, ωB = 45%, and ωf = 25%
Standard deviation:
V (Rp )= V (ωA × RA + ωB × RB + ωf × Rf ) = V (ωA × RA + ωB × RB )
= ωA2 × V (RA ) + ωB2 V (RB ) + 2ωA ωB × Cov (RA , RB )
= ωA2 × V (RA ) + ωB2 V (RB ) + 2ωA ωB × βA βB V (RM )
= 0.32 × 0.32 + 0.452 × 0.42 + 2 × 0.3 × 0.45 × 0.8 × 1.2 × 0.222
√
= 0.053 ⇔ SD(RP ) = 0.053 = 23.03%
Part 2.1. Exercise


A 13% 0.8 30%
B 18% 1.2 40%
A 30%
B 45%
T-bill 25%

Beta?

Part 2.1. Exercise


A 13% 0.8 30%
B 18% 1.2 40%
A 30%
B 45%
T-bill 25%
Beta:
βP = ωA × βA + ωB × βB + ωf × βf
= ωA × βA + ωB × βB
= 0.3 × 0.8 + 0.45 × 1.2 = 0.78
Part 2. Index model
Part 2.2. Alpha and Beta
Part 2.2. Alpha and Beta estimates
The economic intuition of market-index model implies a regression

model - the way to estimate α and β
e } onto {R e }:
Recall if we regress {Ri,t m,t
e e
Ri,t = αi + βi Rm,t + ϵi,t
e
▶ αi is the regression line’s intercept; part of the expected Ri,t
▶ βi is the regression line’s slope
▶ ϵi,t is the regression residuals

Part 2.2. Alpha and Beta estimates - Important formulas
For a single linear regression, the coefficient estimates can be expressed:

e ,R e )
Cov (Ri,t m,t
Exposure to macro factor: βi = e )
Var (Rm,t


e ,R e )
Cov (Ri,t m,t
Var (Rm,t
e ,R e )
Cov (Ri,t
e , Re ) = √
Given Corr (Ri,t √ m,t
m,t e )
Var (Ri,t e )
Var (Rm,t
e )
Std.Dev .(Ri,t e e
βi = e ) × Corr (Ri,t , Rm,t )
Std.Dev .(Rm,t


e ,R e )
Cov (Ri,t m,t
Var (Rm,t
e ,R e )
Cov (Ri,t
e , Re ) = √
Given Corr (Ri,t √ m,t
m,t e )
Var (Ri,t e )
Var (Rm,t
e )
Std.Dev .(Ri,t e e
βi = e ) × Corr (Ri,t , Rm,t )
Std.Dev .(Rm,t
e ] − β E [R e ]
Alpha estimates: αi = E [Ri,t i m,t

Part 2.2. Market index’s alpha and betas
Market portfolio’s alpha

αm = 0
Market portfolio’s beta:
βm = 1

Part 2.2. R-squared - Important formulas
For single linear regression, the coefficient estimates can be expressed:

e ) = β 2 Var (R e ) + Var (ϵ )
Recall: Var (Ri,t i m,t i,t

Part 2.2. R-squared - Important formulas
For single linear regression, the coefficient estimates can be expressed:

e ) = β 2 Var (R e ) + Var (ϵ )
Recall: Var (Ri,t i m,t i,t
βi2 Var (Rm,t

e )
R2 = e )
Var (Ri,t
R2 e )
βi2 Var (Rm,t
=
1 − R2 Var (ϵi,t )

Part 2.2. Beta and R-squared
βi and R 2 describe different properties

In regression:
▶ R 2 how correlated Ri,t
e e
is with Rm,t
R 2 = {Corr (Ri,t
e e
, Rm,t )}2
▶ βi indicates the slope of the regression line

Part 2.2. Beta and R-squared

βi and R 2 describe different properties
In regression:
▶ R 2 how correlated Ri,t
e e
is with Rm,t
R 2 = {Corr (Ri,t
e e
, Rm,t )}2
▶ βi indicates the slope of the regression line
Economically:
▶ R 2 describes how much portion of a stock’s variation comes from the
macro factor
▶ βi describes how sensitive of a stock’s return is to the macro factor’s
movement

Part 2.2. Security Characteristic Line



Part 2.2. Exercise III
Now you want to estimate the second size decile’s beta, r-squared,
the correlation with the market
You know:
▶ σ(Rm ) = 0.051
▶ σ(Rdec2 ) = 0.056
▶ Corr (Rm , Rdec2 ) = 0.88
Calculate:
▶ βdec2 =?


You know:
▶ σ(Rm ) = 0.051
▶ σ(Rdec2 ) = 0.056
▶ Corr (Rm , Rdec2 ) = 0.88
Calculate:
▶ βdec2 =?
Cov (Rdec2 , Rm )
βdec2 =
σ 2 (Rm )
Corr (Rdec2 , Rm ) × σ(Rm ) × σ(Rdec2 )
=
σ 2 (Rm )
0.88 × 0.051 × 0.056
=
0.0512
= 0.9663
You know:
▶ σ(Rm ) = 0.051
▶ σ(Rdec2 ) = 0.056
▶ Corr (Rm , Rdec2 ) = 0.88
Calculate:
▶ residual standard deviation: σ(ϵdec2 ) =?


You know:
▶ σ(Rm ) = 0.051
▶ σ(Rdec2 ) = 0.056
▶ Corr (Rm , Rdec2 ) = 0.88
Calculate:
▶ residual standard deviation: σ(ϵdec2 ) =?
σ 2 (Rdec2 )= βdec2
2
σ 2 (Rm ) + σ 2 (ϵdec2 )
⇔ σ 2 (ϵdec2 )= σ 2 (Rdec2 ) − βdec2
2
σ 2 (Rm )
= 0.0562 − 0.96632 × 0.0512 = 0.0007
√
⇔ σ(ϵdec2 )= 0.0007 = 2.66%

You know:
▶ σ(Rm ) = 0.051
▶ σ(Rdec2 ) = 0.056
▶ Corr (Rm , Rdec2 ) = 0.88
Calculate:
▶ R-squared of the market index model for decile 2?

You know:
▶ σ(Rm ) = 0.051
▶ σ(Rdec2 ) = 0.056
▶ Corr (Rm , Rdec2 ) = 0.88
Calculate:
▶ R-squared of the market index model for decile 2?
R 2 = Corr (Rdec2 , Rm )2
= 0.882
= 0.7744

Part 2.2. Estimate β in practice
In practice, securities’ αs and βs are estimated in OLS regressions
OLS regression estimator β̂i is often referred to as ”historical beta”


▶ when the number of observations (T ) increases - we use longer sample
for estimation
▶ when the firm-specific variance decreases - a portfolio’s beta estimate
is more accurate than individual stocks’


▶ when the number of observations (T ) increases - we use longer sample
for estimation
▶ when the firm-specific variance decreases - a portfolio’s beta estimate
is more accurate than individual stocks’
However, stocks’ true betas are also changing - so we cannot use the
entire history of a stock to estimate OLS beta.

Part 2.2. Estimate βs
In practice, with monthly data, 5-7 years seems to give good trade-off
between the two
▶ 5-7 years allow greater accuracy arising from more observations
▶ also higher accuracy to capture time-varying true betas

Part 2.2. Estimate βs
In practice, with monthly data, 5-7 years seems to give good trade-off
between the two
▶ 5-7 years allow greater accuracy arising from more observations
▶ also higher accuracy to capture time-varying true betas
We can also use higher frequency returns to estimate betas, e.g., daily
returns
▶ allows a shorter window in calendar time
▶ It can be problematic for stocks that are not very liquid

Part 2.2. Empirical estimation of betas

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1. Non-diversifiable and Diversifiable risk 2.

Investments and Portfolio Analysis

Dr. Maxime Couvert

University of Hong Kong

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 1 / 49

1. Non-diversifiable and Diversifiable risk

Part 1.1. Variance of a portfolio’s return

where ωi is the weight in asset i ( N

as Cov (Ri , Ri ) = σp2 , the variance can be expressed as:

If ωi ’s have comparable magnitudes across securities ⇒ N, variance

Part 1.1. Diversification - a simplified setting

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 3 / 49

Part 1.1. Diversification speed

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 4 / 49

Part 1.1. Diversification speed (continue)

With Corr (Ri , Rj ) = 0.3, for any pair (i, j)

Diversification effect occurs pretty quickly (with 30 stocks the

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 5 / 49

Part 1.1. Benefits of diversification

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 6 / 49

Part 1.1. Portfolio risk vs. the number of stocks

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 7 / 49

Part 1.1. Computational challenge

To calculate the portfolio variance, even in the limiting case, one

Too many covariances and variances to estimates

Estimation errors can accumulate 2 million times and possibly causing

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 8 / 49

Part 1.2. Single index model

All other risk in a stock is idiosyncratic (or firm-specific)

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 9 / 49

Part 1.2. One common source of risk

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 10 / 49

Part 1.2. What do the assumptions mean?

News cannot be anticipated a priori

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 11 / 49

Part 1.2. Returns structure

More formally, we can state these elements as:

1 Ri ≡ Security i’s return

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 12 / 49

Part 1.2. The level of risk

Stock i ’s total risk = Systematic risk + Firm-specific risk

Var (Ri ) = Var (mi ) + Var (ei )

Recall mi is driven by the common macro conditions

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 13 / 49

Part 2.1. Market index model

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 14 / 49

Part 2.1. Market index model

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 15 / 49

Part 2.1. Market index model

Part 2.1. Market and Non-Market Returns

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 17 / 49

Part 2.1. The variance matrix

Now, variance-covariance matrix becomes much simpler

Now, the calculation of covariance can be simplified:

Cov (Rie , Rje ) = βi βj Var (Rm

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 18 / 49

Part 2.1. Combining assets - A general case

Consider a portfolio p of N assets, 1,2,... and N,

Dr. Maxime Couvert (HKU) FINA2320 - Lecture 6 Fall, 2023 19 / 49

Part 2.1. Exercise

Stock Expected return Beta Standard deviation

Calculate for this portfolio: