UNIT 7

INDEX MODELS
A. A single factor security market
B. The single-index model
C. Estimating single-index model
D. Portfolio construction and the Single-index model
E. Practical Aspects of Portfolio Management with
Index Model
 Financial Investments

UNIT 2 – Fixed Income Securities

A. Single-factor security market

The single factor model is related to the Capital
Asset Pricing Model (CAPM), explaining that
investors need to be compensated for two main
things: time value and risk

Risk-free rate Risk measure that compares

returns of the asset to returns
of the market, market premium 2
 Financial Investments

UNIT 2 – Fixed Income Securities

A. Single-factor security market

Factor models for asset returns are used to
Ø Decompose risk and return into explainable
and unexplainable components
Ø Generate estimates of abnormal return
Ø Describe the covariance structure of returns
Ø Predict returns in specified stress scenarios
Ø Provide a framework for portfolio risk analysis 3
 Financial Investments

UNIT 2 – Fixed Income Securities

B. Single-Index Model (SIM)

Statistical model of security returns which
specifies 2 sources of uncertainty:
1. Systematic (macroeconomic) uncertainty
(represented by a single index of stock
returns)
2. Unique (microeconomic) uncertainty
(represented by a security-specific random
component) 4
 Financial Investments

UNIT 2 – Fixed Income Securities

B. The Single-Index Model (SIM):
Stocks tend to move together driven by the same
economic forces hence the modelling the way
returns are generated by a simple equation:
ri = αi + βi I + ei
ri expected return on the security i
ei error term with the mean of zero and a constant
standard deviation
αj intercept of a straight line or alpha coefficient
I expected return on an index
βi slope of straight line or beta coefficient 5
 Financial Investments

UNIT 2 – Fixed Income Securities

How to calculate the Beta coefficient

BUT it relies solely on past returns,

and ignores the unsystematic risk factors that are
specific to the firm
6
 Financial Investments

UNIT 2 – Fixed Income Securities

B. The Single-Index Model (SIM):

Return: daily return on each of the selected stocks
Rit = Pit - 1 Rit = return on security i on time t
Pit-1 t = price of security at time t
t-1 = price of security a year earlier
Standard deviation: average returns of individual
returns or portfolio are adjusted to that of risk free
return
Excess return = Ri – Rf
βi 7
 Financial Investments

UNIT 2 – Fixed Income Securities

• Sample monthly return data from SPDR sector

ETFs between Jan 1, 2000 and Jan 1, 2015
• Factor model consist on the asset’s relationship
to the market return of the S&P500
• In order to reduce sample bias, we model on
intervals of 10 monthly returns, testing is done
on the remaining data
• Ratio used is 75% training, 25% testing
8
 Financial Investments

UNIT 2 – Fixed Income Securities

Example: download monthly return data from

Jan 1, 2000 to Jan 1, 2015 for
XLY (Consumer Discretionary)
XLP (Consumer Staples)
XLE (Energy)
XLF (Financials)
XLV (Healthcare) XLB (Materials)
XLI (Industrials) XLK (Technology)
XLU (Utilities) 9
 Financial Investments

UNIT 2 – Fixed Income Securities

Example:

MSE Mean Square Error:

average of the squares
of the errors 10
 Financial Investments

UNIT 2 – Fixed Income Securities

• Example: The SIM explains the 10 sector ETFs’

risks and returns
• R^2 suggests that market premium makes up a
portion of return on the financial, industrial,
discretionary, tech, and materials sectors - as
these industries tend to move with the market
• For example, utilities had the lowest
significance 11
 Financial Investments

UNIT 2 – Fixed Income Securities

• In times of positive returns on the market, the

opposite takes place; consumers will shift
spending habits towards discretionary goods,
and usually maintain the same amount of
spending on utilities
• We captured some of the risk/return profile,
but what about the other portions?
12
 Financial Investments

UNIT 2 – Fixed Income Securities

The returns of the industrials ETF (blue line) is more in line
How to find with that of the market (purple line), making that factor for
this asset more significant than for utilities (red line).
the factors
that derive
this return?
Turning to a
3-Factor
Model
13
 Financial Investments

UNIT 2 – Fixed Income Securities

Predicted beta is stronger for industrials than for utilities

The Beta regression performs in a plot of returns on the

asset versus the market
Beta is a much better fit for XLI than XLU 14
 Financial Investments

UNIT 2 – Fixed Income Securities

B. Estimating Single-Index Model (SIM):

An index is chosen so that ej and ei are indeed
uncorrelated for any two assets
• The stock market (a value-weighted portfolio)
is an adequate proxy to capture all
macroeconomic fluctuations
• In practice, a popular choice is for the S&P500
index to be the index in the SIM
15
 Financial Investments

UNIT 2 – Fixed Income Securities

Example: S&P500 is market proxy. Analyse the

General Electric stock (GE), and usw weekly
returns, αj = -0.07%, βj = 1.44
If S&P500 to increase by 5% next week, then
according to the market model, the return on GE
next week to be:
E [rGE ] = αGE + βGE E [rM]
E [rGE ] = -0.07% + 1.44 × 5% = 7.13%
16
 Financial Investments

UNIT 2 – Fixed Income Securities

C. Estimating the SIM: 3 Types of Factor Models

1. Macroeconomic factor model - Factors from
economic and financial time series
2. Fundamental factor model – Factors created
from observable asset characteristics
3. Statistical factor model – Factors
unobservable and extracted from asset
returns 17
 Financial Investments

UNIT 2 – Fixed Income Securities

Three Models: Macroeconomic Factor Models

Rit = αi+βi ft + εit
ft = observed economic/financial time series
Econometric problems: - Choice of factors
- Estimate factor betas, βi, and residual
variances, σ2i, using time series regression
techniques
- Estimate factor covariance matrix, Ωf , from
observed history of factors 18
 Financial Investments

UNIT 2 – Fixed Income Securities

Three Models: Macroeconomic Factor Models

Sharpe’s Single Factor Model is a macro-
economic factor model :
Rit =αi+ βi RMt + εit, i=1,...,N; t = 1,...,T
where RMt denotes the return or excess return
(relative to the risk-free rate) on a market index
(typically a value weighted index like the S&P
500 index) in time period t 19
 Financial Investments

UNIT 2 – Fixed Income Securities

Three Models: Fundamental Factor Models

Use observable asset specific characteristics like
industry classification, market cap, style
classification (value, growth) to determine the
common risk factors
• Factor betas are constructed from observable
asset characteristics (i.e., B is known)
• Factor realizations, ft, are constructed in 2
ways: BARRA and Fama-French 20
 Financial Investments

UNIT 2 – Fixed Income Securities

Fundamental Factor Models: BARRA Approach

• Observable asset specific fundamentals
treated as the factor betas, βi
• The factor realizations at time t, ft, are
unobservable
• A T cross-section regressions is run to
estimate the factor realizations at time t given
the factor betas 21
 Financial Investments

UNIT 2 – Fixed Income Securities

Fundamental Factor Models: Fama-French approach

• Sort the cross-section of assets , hedge the
portfolio long in the top quintile of the sorted
assets, and short in the bottom quintile
• The observed return at time t is the factor
realization for the asset specific characteristic
• The factor betas for each asset are estimated using
N time series regressions
22
 Financial Investments

UNIT 2 – Fixed Income Securities

Three Models: Statistical Factor Models for

Returns
• The factor realizations ft are not directly
observable and must be extracted from the
observable returns Rt using statistical methods
• If N > T , then the sample covariance matrix of
returns becomes singular
23
 Financial Investments

UNIT 2 – Fixed Income Securities

D. Portfolio construction and the SIM:

Utility of SIM
• The SIM does not fully characterize the
determinants of expected returns - how do αj
varies across assets?
• SIM assumes that the correlation structure
across assets depends on a single factor – but
more factors may be needed
24
 Financial Investments

UNIT 2 – Fixed Income Securities

Ø The SIM Helps to Derive the Optimal Portfolio

for Asset Allocation (the Tangent Portfolio T) by
reducing the Necessary Inputs to the Markowitz
Portfolio Selection Procedure
Portfolio P, with the tangency portfolio T
• All the risky assets in the portfolio selection
model to compute the weights of T
25
 Financial Investments

UNIT 2 – Fixed Income Securities

With n risky assets, we need 2n + (n2 – n)/2
parameters:
n = 1.000
number of parameters
= 1000+ 1000 + 499.500= 501.500
n expected returns E[rj]
n=2, Number of parameters=2 + 2 + 1 = 5
n return standard deviations σj n(n-1)/2
n=8, number of parameters=8 + 8 + 28 = 44
correlations (or covariances)
26
 Financial Investments

UNIT 2 – Fixed Income Securities

Example
With large n:
Large estimation error,
Large data requirements (for monthly estimates,
with n=1.000, need at least 1.000 months, i.e.,
more than 83 years of data)

27
 Financial Investments

UNIT 2 – Fixed Income Securities

Assuming the SIM is correctly specified, we only
need the following parameters:
n αj parameters 1 E[rI]
n βj parameters 1 σ2[r]
n σ2[e ] parameters j
These parameters generate all the E[rj], σj , σji
The parameters arte obtained by estimating the
index model for each of the n securities.
Example: with 100 stocks need 302 parameters
28
 Financial Investments

UNIT 2 – Fixed Income Securities

Example: How is the return on GE driven by the

return on a market index M, measured by S&P500?
1. Collect historical data on rGE and rM
2. Run a simple linear regression of rGE against rM:
rGE = αGE + βGE r M + e GE
where αGE (“alpha”) is the intercept, βGE (“beta”) is
the slope, eGE is the regression error
The fitted regression line is called the Security
Characteristic Line (SCL) 29
 Financial Investments

UNIT 2 – Fixed Income Securities

Example: The variance of GE is

σ GE2 = βGE2 σM2 + σ2[eGE]
Where σ[eGE] is the “Std. Dev. Of Error”

Over the sample, σM = 1.28% (from other data):

σ GE2 = (1.44)2 (1.28)2 + (2.08)2 = 3.40 + 4.33 = 7.73
R2 = β 2GE σ 2M = 3.40 = 0.44
σ2GE 7.73
R2 is called the coefficient of determination 30
 Financial Investments

UNIT 2 – Fixed Income Securities

Example: The variance of GE

R2 is called the coefficient of determination,
giving the fraction of the variance of the
dependent variable (the return on GE) that is
explained by movements in the independent
variable (the return on the Market portfolio)

31
 Financial Investments

UNIT 2 – Fixed Income Securities

E. Practical aspects of portfolio management

Active and Static Portfolios
o Active portfolios have weights that change
over time due to active asset allocation
o Static portfolios have weights that are fixed
over time (e.g. equally weighted portfolio)
o Factor models can be used to analyze the risk
of both active and static portfolios 32
 Financial Investments

UNIT 2 – Fixed Income Securities

E. Practical aspects of portfolio management

Ø Non normality: daily stock return for a security
exhibits volatility which is not observed with
monthly data
Ø Distributions of daily returns are fat-tailed
relative to a normal distribution [Fama (1976)]
33
 Financial Investments

UNIT 2 – Fixed Income Securities

Fat-tailed distribution [Fama (1976)]

34
 An outlier is an observation that lies an abnormal
distance from other values in a random sample from a
population
35
 Financial Investments

UNIT 2 – Fixed Income Securities

E. Practical aspects of portfolio management

Variance estimation:
Ø 1st issue is the time-series properties of daily
data: daily excess returns can exhibit serial
dependence
Ø 2nd issue: the variance of stock returns
increases for the days immediately around
events such as earnings announcements 36
 Financial Investments

UNIT 2 – Fixed Income Securities

• Example: mthly closing price of stocks listed

on National Stock Exchange (NSE) and mthly
closing index value of CNX BANK INDEX used
for construction of optimal portfolio applying
Sharpe’s Single Index Model
• The closing prices collected for a 5 yr period
• Study takes 9 banks listed on NSE according to
market capitalization 37
 Financial Investments

UNIT 2 – Fixed Income Securities

91 days T-Bill used as a proxy for risk free rate

CNX Bank Index: most liquid Bank in India

38
 Financial Investments

UNIT 2 – Fixed Income Securities

Table: out of 10 banks, 2 banks are having excess

return, and their values are more than cut-off value

39
 Financial Investments

UNIT 2 – Fixed Income Securities

Determining the optimal portfolio (Jan 09 – Dec 13)
The cut-off point

40
 Financial Investments

UNIT 2 – Fixed Income Securities

Cut-off value:
• Ranking of the stocks is done on the basis of their
excess return to beta but Portfolio managers
includes stocks with higher ratios
• Selection of stocks depends on a unique cut-off
rate such that all stocks with higher ratios of (Ri -
Rf) / βi are included and the stocks with lower
ratios are left out
• The cutoff point is denoted by C*
41
 Financial Investments

UNIT 2 – Fixed Income Securities

Cut-off value:
variance in the
market index

variance of a stock’s
movement that is not associated with the
movement of the market index – the stock’s
unsystematic

42
 Financial Investments

UNIT 2 – Fixed Income Securities

Determining the weights for an Optimal Portfolio

• The optimal portfolio consists of 2 securities

• All securities which have excess return to beta
ratio greater than that of cut-off point are
included in the portfolio
• Such portfolio is the optimum portfolio 43
 Financial Investments

UNIT 2 – Fixed Income Securities

Determining the weights for an Optimal Portfolio

The study that follows 10 stocks needs 32 numbers
of inputs as against 65 numbers of inputs for
Markowitz Model
Ø Therefore implementation of Markowitz model is
more time-consuming and complex
Ø The framework of Sharpe's single index model for
optimal portfolio construction is simpler 44