Chapter 8

Single Index Model

FINA 340
Investments
Problems with the Markowitz Procedure

•1.matrix.
The model requires a huge number of estimates to fill the covariance
 
 Suppose there are a total of stocks. You need to estimate:
 estimates of expected returns;
 estimates of variance and covariances.
 You need to estimate 5,150 coefficients for a total of 100 stocks; you
need to estimate about 4.5 million coefficients for a total of 3,000
stocks.
2. The model does not provide any guideline to forecast risk premiums that
are essential to construct the efficient frontier of risky assets.

Index model: explicitly decompose risk into systematic and firm-specific

components thus largely simplifies estimation of the covariance matrix.
Single Index Model
ri  E (ri )  i m  ei
•  
 m = a common macroeconomic factor that affects all security returns. It has
zero mean and standard deviation. The S&P 500 is often used as a proxy
for m.
 βi = response of an individual security’s return to the common factor, m.
Beta measures systematic risk.
 ei = firm-specific surprises with zero mean and standard deviation.
 m and ei are uncorrelated: Corr(m, ei) = 0
 Advantage:
– Reduces the number of inputs for diversification
– Easier for security analysts to specialize
 Regression Equation: Ri  t    i   i RM  t   ei  t 
 Expected return-beta relationship: E  Ri    i   i E  RM 
Single Index Model
• Risk and covariance:
• Variance = Systematic risk and Firm-specific risk:
 i2   i2 M2   2 (ei )
• Covariance = product of betas x market index risk:
Cov(ri , rj )  i  j M2
• Correlation = product of correlations with the market index

i  j M2 i M2  j M2
Corr (ri , rj )    Corr (ri , rM ) xCorr (rj , rM )
 i j  i M  j M
Example
Stock MV Beta Mean Excess Standard
Return Deviation
A $3,000 1.0 10% 40%
B $1,940 0.2 2% 30%
C $1,360 1.7 17% 50%
• Suppose the standard deviation of the market index portfolio is
25%.
– What is the covariance between stock A and stock B?
– What is the covariance between stock B and the index?
– Break down the variance of stock B into its systematic and firm-specific
components.
Example: Answers
•• Covariance
  between stock A and stock B:

• Covariance between stock B and the index:

• Break down the variance of stock B into its systematic and

firm-specific components.

• Therefore, systematic risk of B (in standard deviation) is ;

firm-specific risk (in standard deviation) is .
Portfolio Risk and Return
•• Portfolio
  alpha, beta, and standard deviation:

• For a equally-weighted portfolio:

Example
Suppose that the index model for stocks A and B is estimated with
the following results: (We use a linear regression model) We regress
the excess returns of stock A or B on the excess returns of the
market index returns by using the past 36 months data. We obtain:
RA = 1.0% + 0.9 RM + eA
RB = -2.0% + 1.1 RM + eB
σM =20%, σe(A) =30%, σe(B) =10%
1) Find the covariance between A and B.
2) Find the standard deviations of A.
3) Suppose we form an equally-weighted portfolio of stocks A and
B. Break down the variance of the portfolio into systematic and
non-systematic variances.
Example: Answer
•• Covariance
  between A and B is

• Standard deviations of A is

• Variance of an equally-weighted portfolio P of stocks A and B:

• Thus the systematic variance of P is 4% and the firm-specific

variance of P is 2.5%.
Example: HP’s Security Characteristic
Line (SCL)
RHP  t    HP   HP RS & P 500  t   eHP  t 
Regression Statistics for the SCL of HP

  𝛽 2 𝜎 2𝑆𝑃 500
𝑅2 =
𝜎 2𝐻𝑃
Example
Suppose we estimate the index model by using a linear regression
model and obtain the following results:
RA=2% + 0.5 RM + eA and RB=4% + 0.9 RM + eB
σM = 15%, R2 (A) = 0.35, R2 (B) = 0.65
a) What is the standard deviation of A and B?
b) Which has greater market risk?
c) Which has more firm-specific risk?
d) For which stock does market movement explain a greater
fraction of return variability?
Example: Answer
•• Standard
  deviation of A and B:

• Systematic variance of A is less than that of B:

Example: Answer
•• Firm-specific
  variance of A and B:

• Thus firm-specific variance of A is greater than that of B.

• As , market movement explain a greater fraction of return
variability of B than A.