SINGLE INDEX MODELS

Advantages of the Single Index Model

Input list of Markowitz model n estimates of expected return n estimates of variances n(n-1)/2 estimates of covariance Reduces the number of inputs for diversification Easier for security analysts to specialize
Ri = E(ri) +ei Ri =E(ri) + m +ei 2i =2m +2 (ei) (1) (2) (3)

Derivation of Single factor model

Cov(Ri,Rj) = Cov (m+ei ,m+ei) = Cov(m,m)+ Cov (ei,ej) =2M
Ri =E(ri) + m+ ei 2i =i2 2m+ 2(ei) (4) (5)

Cov(Ri,Rj) = Cov (im+ei , jm+ej) = i jCov(m,m)+ Cov (ei,ej) =i j2M

Single Factor Model

ri = E (ri ) + i m + ei
i = index of a securities particular return to the factor m = Unanticipated movement related to security returns ei = Assumption: a broad market index like the S&P 500 is the common factor.

Single-Index Model
Regression Equation:

Rt (t ) = i + t RM (t ) + ei (t )
Expected return-beta relationship:

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

Single-Index Model Continued

Risk and covariance:
Total risk = Systematic risk + Firm-specific 2 risk: i2 = i2 M + 2 (ei ) Covariance = product of betas x market index risk: 2 Cov(ri , rj ) = i j M Correlation = product of correlations with the market index
2 2 2 i j M i M j M Corr (ri , rj ) = = = Corr (ri , rM ) xCorr (rj , rM ) i j i M j M

Concept check 1
Stock Capitalisation beta Mean excess returns Standard deviation A $ 3000 1 10% 40% B 1940 0.2 2% 30% C 360 1.7 17% 50% Standard deviation of the market portfolio is 25% a. What is the mean excess return of the index portfolio? b. What is the covariance between stock A and B? c. What is the covariance between stock B and the index? d. Break down the variance of stock B into its systematic and firm specific components. a. 3000/6300*10+1940/6300*2+1360/6300*17 =9.05% b. 1*0.2* 0.252 = .0125 c. 0.2 *0.252 = .0125 d. Systematic =0.22 *.252 = .0025 Firm specific = 0.302 - .0025 =.0875

The set of estimates needed for the single index model

n estimates of stocks expected returns if the market is neutral ,i n estimates of sensitivity coefficients (i)
N estimates of firm specific variances ,2(ei) 1 estimate for market risk premium, E(Rm) 1 estimate of variance of common macroeconomic factor , 2m

Concept check 2
Suppose RA =1% +0.9 RM +eA RB = -2%+1.1 RM +eB (eA) =30% (eB) =10% M =20% Find the standard deviation of each stock and covariance between them. Stock A = 0.92 *(20)2 + 302 = 1224 SD = 35% Stock B =1.12 *(20)2 + 102 = 584 SD = 24% The covariance = .9* 1.1 * 202 = 396

 Portfolios variance:
2 P 2 P

Index Model and Diversification

= + (eP )
2 M 2

Variance of the equally weighted portfolio of firm-specific components:

1 2 1 2 (eP ) = (ei ) = (e) n i =1 n
n 2 2

When n gets large, 2 (eP ) becomes negligible

Figure 8.1 The Variance of an Equally Weighted Portfolio with Risk Coefficient p in the Single-Factor Economy

Concept check 3
Reconsider the two stocks in concept check 2. Suppose we form an equally weighted portfolio of A and B. What will be the nonsystematic standard deviation of that portfolio? 2(ep) =0.52 [ .302 + .102 ]
= .0250 ep = .158 =15.8%

Estimating the single index Model

Security Characteristic Line RHP (t) =HP +HP RS&P500(t) +eHP(t)

Figure 8.2 Excess Returns on HP and S&P 500 April 2001 March 2006

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

Excel Output: Regression Statistics for the SCL of Hewlett-Packard

H0: =0

Calculation of Risk
2HP = .7162/59 =.012 per month Monthly SD =11% Annualized standard deviation =38.17 (11 *sqrt 12) 2 HP2S&P500 =.3752 2eHP =.3410/58 =0.0057796 per month Monthly SD of HPs residual =7.67% Alternatively, Directly the square root of MS for residual Annualised residual SD = 7.67 *sqrt 12 =26.6%

Alpha and Security Analysis

Single index model provides the framework it provides for macro economic 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, 2 ( e i )

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

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

Optimal Risky Portfolio of the SingleIndex Model

Maximize the Sharpe ratio Expected return, SD, and Sharpe ratio:
E ( RP ) = P + E ( RM ) P = wi i + E ( RM ) wi i
i =1 i =1 2 n +1 n +1 2 2 2 2 2 2 P = P M + (eP ) = M wi i + wi (ei ) i =1 i =1 E ( RP ) SP = 1 2 1 2 n +1 n +1

Optimal Risky Portfolio of the SingleIndex Model Continued

Combination of: Active portfolio denoted by A (assuming additional firm specific risk) Market-index portfolio, the (n+1)th asset which we call the passive portfolio and denote by M (efficient diversification) Modification of active portfolio position: 0 wA * wA = 0 1 + (1 A ) wA When

A = 1, w = w
* A

0 A

The Information Ratio

The Sharpe ratio of an optimally constructed risky portfolio will exceed that of the index portfolio (the passive strategy):

A = + sP sM (eA )
2 2

Steps for forming optimal risky portfolio

Compute initial position of each security in the active portfolio as vi0 =i/2(ei) Scale those initial position to force portfolio weights to sum 1 wi =wi0 /i=1to n wi0 Compute alpha of active portfolio A=i=1to n wii Compute beta of active portfolio:A= i=1 to n wii Compute residual variances of active portfolio 2(eA) = ito n wi2 2(ei)

Steps for forming optimal risky portfolio

Compute initial position in active portfolio: W0A =[i/2(ei)/E(RM)/2M] (Note: E(RM) is the risk premium) Adjust the initial position in the active portfolio
0 w A = w* A 0 1 + (1 A ) wA

Optimal risky portfolio now has weights W*M= 1-W*A Risk premium on of optimal risky portfolio E(Rp) =(W*M+W*A A) E(RM) +W*A A Compute the variance of the optimal risky portfolio 2p = (W*M+W*A A) 2 2M +[w*A (eA)]2

Question 17(a)
Alpha ()[extra market expected return] i = ri [rf + i(rM rf ) ] A = 20% [8% + 1.3(16% 8%)] = 1.6% B = 18% [8% + 1.8(16% 8%)] = 4.4% C = 17% [8% + 0.7(16% 8%)] = 3.4% D = 12% [8% + 1.0(16% 8%)] = 4.0% Expected excess return E(ri ) rf 20% 8% = 12% 18% 8% = 10% 17% 8% = 9% 12% 8% = 4%

Stocks A and C have positive alphas, where as stocks B and D have negative alphas. The residual variances are: 2(eA ) = 582 = 3,364 2(eB) = 712 = 5,041 2(eC) = 602 = 3,600 2(eD) = 552 = 3,025

Question 17(b)[Treynor Black technique]

Initial position A B C D Total 1.6/3364=0.000476 -4.4/5041=0.000873 3.4/3600=0.000944 -4/3025=0.001322 0.000775

wi =wi0 /i=1to n wi0

0.6142 1.1265 1.2181 1.7058 1.0000

With these weights, the forecast for the active portfolio is: = [0.6142 * 1.6] + [1.1265 * ( 4.4)] [1.2181 * 3.4] + [1.7058 * ( 4.0)] = 16.90% = [0.6142 * 1.3] + [1.1265 *1.8] [1.2181 * 0.70] + [1.7058 * 1] = 2.08 2(e) = [(0.6142)2 * 3364] + [1.12652 * 5041] + [(1.2181)2 *3600] + [1.70582 * 3025] = 21,809.6 (e) = 147.68%

Question 17(b)
The optimal risky portfolio has a proportion w* in the active portfolio, computed as follows:

/ 2 (e) 16 .90 / 21,809 .6 w0 = = = 0 .05124 2 2 [ E ( r M ) rf ] / M 8 / 23

The negative position is justified for the reason stated earlier. The adjustment for beta is:
w0 0.05124 w* = = = 0.0486 1 + (1 ) w 0 1 + (1 2.08)(0.05124)

Since w* is negative, the result is a positive position in stocks with positive alphas and a negative position in stocks with negative alphas. The position in the index portfolio is: 1 (0.0486) = 1.0486

Question 17(c)
The information ratio for the active portfolio is computed as follows: A = /(e)= 16.90/147.68 = 0.1144 A2 = 0.0131 Hence, the square of Sharpes measure (S) of the optimized risky portfolio is:
8 2 + = S2 = S2 A + 0.0131 = 0.1341 M 23
2

S = 0.3662 Compare this to the markets Sharpe measure: SM = 8/23 = 0.3478 The difference is: 0.0184

Question 17(d)[Exact makeup of the complete portfolio]

P = wM + (wA A ) = 1.0486 + [(0.0486) 2.08] = 0.95 E(RP) = P + PE(RM) = [(0.0486) ( 16.90%)] + (0.95 8%) = 8.42% = + (e ) = (0.95 23) + ((0.0486 ) 21,809.6 ) = 528.94
2 P 2 P 2 M 2 2 2 P

P = 23.00%
y= 8.42 = 0.5685 0.01 2.8 528.94

In contrast, with a passive strategy:

8 y= = 0.5401 2 0.01 2.8 23

This is a difference of: 0.0284

Question 17(d)
The final positions of the complete portfolio are:
Bills M A B C D 1 0.5685 = 0.5685 l.0486 = 0.5685 (0.0486) (0.6142) = 0.5685 (0.0486) 1.1265 = 0.5685 (0.0486) (1.2181) = 0.5685 (0.0486) 1.7058 = 43.15% 59.61% 1.70% 3.11% 3.37% 4.71% 100.00% [sum is subject to rounding error]

THE CAPITAL ASSET PRICING MODEL

Capital Asset Pricing Model (CAPM)

It is the equilibrium model that underlies all modern financial theory Provides benchmark rate of return Educated guess as to E(r) on assets that have not yet been traded in the market place. Derived using principles of diversification with simplified assumptions Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development

Assumptions
Individual investors are price takers Single-period investment horizon Investments are limited to traded financial assets No taxes and transaction costs

Assumptions Continued
Information is costless and available to all investors Investors are rational mean-variance optimizers There are homogeneous expectations

Resulting Equilibrium Conditions

All investors will hold the same portfolio for risky assets market portfolio Market portfolio(M) contains all securities and the proportion of each security is its market value as a percentage of total market value Not only will the market portfolio be on the efficient frontier ,but it also will be tangency portfolio to the optimal CAL (CML).All investors hold M as their optimal risky portfolio, differing only in amount invested in it vs.risk free asset.

Resulting Equilibrium Conditions Continued

Risk premium on the market portfolio depends on the average risk aversion of all market participants and its risk. Risk premium on an individual security is a function of its covariance with the market. i =Cov(ri,rm)/2M Risk premium on Individual security: E(ri) rf =Cov(ri,rm)/2M[E(rm)-rf] =i[E(rm)-rf]

The Efficient Frontier and the Capital Market Line

All assets have to be included in the market portfolio .The only issue is the price at which Investors will be willing to include a stock in their optimal risky portfolio

Market Risk Premium

The risk premium on the market portfolio will be proportional to its risk and the degree of risk aversion of the investor:
2 E (rM ) rf = A M 2 where M is the variance of the market portolio and

A is the average degree of risk aversion across investors

Y =E(rp) rf /A 2P

Return and Risk For Individual Securities

Bordered covariance Matrix wGE[w1Cov(r1,rGE)+ w2Cov (r2,rGE) +wGECov(rGE,rGE)+wnCov(rn,rGE)] It is Covariance of GE with market portfolio GEs contribution to variance =wGECov(rGE,rM)

If Cov of GE with rest of the market is negativenegative contribution to the portfolio risk If Cov is positive then positive contribution to overall portfolio risk.

Return and Risk For Individual Securities

The individual securitys contribution to the risk of the market portfolio i.e wGECov(rGE,rM)=GEs Contribution to the variance An individual securitys risk premium is a function of the covariance of returns with the assets that make up the market portfolio i.e wGE[E(rGE) rf] =GE contribution to the risk premium

Using GE Text Example

Covariance of GE return with the market portfolio: n n

Cov(rGE , rM ) = Cov rGE , wk rk = wk Cov(rk , rGE ) k =1 k =1

Therefore, the reward-to-risk ratio for investments in GE would be:

E (rGE ) rf E (rGE ) rf GE's contribution to risk premium wGE = = GE's contribution to variance wGE Cov( rGE , rM ) Cov( rGE , rM )

 Reward-to-risk ratio for investment in market portfolio:

Market risk premium E (rM ) rf = 2 Market variance M

Using GE Text Example Continued

Reward-to-risk ratios of GE and the market portfolio: E (rGE ) rf E (rM ( rf )

Cov(rGE , rM ) =
2 M

And the risk premium for GE:

E (rGE ) rf = Cov(rGE , rM )

2 M

E (rM ) rf

E(rGE) =rf +GE[E(rM)-rf]

Expected Return-Beta Relationship

w1E(r1) =w1rf+w11[E(rM)-rf] + w2(Er2) =w2rf +w22[E(rM)-rf] +.=. +wnE(rn) =wn rf +wnn [E(rM)-rf] E(rp) =rf +p [E(rM)-rf]

Expected Return-Beta Relationship

CAPM holds for the overall portfolio because:

E (rP ) = wk E (rk ) and

k This also holds for the market portfolio:

P = wk k

E (rM ) = rf + M E ( r ) r M f
M =Cov(rM,rM) /2M =1 In an efficient market investors receive high expected returns only if they are willing to bear risk

Concept check
Suppose that the risk premium on the market portfolio is estimated at 8% with a standard deviation of 22%.What is the risk premium on a portfolio invested 25% in GM and 75% in Ford, if they have betas of 1.10 and 1.25 respectively?
p = .75*1.25+ .25* 1.10 = 1.2125 The portfolio risk premium = 1.2125 * 8 = 9.7%

The Security Market Line

SML is the graphical representation of exp returnbeta relationship Reward or risk premium on individual assets ,depends on the contribution of the individual asset to the risk of the portfolio. CML Vs SML SML provides a benchmark for the evaluation of investment performance Fairly priced assets plot exactly on SML CAPM is also useful in capital budgeting decisions.

Figure 9.2 The Security Market Line

Figure 9.3 The SML and a PositiveAlpha Stock

Question
Stock XYZ has an expected return of 12% ,=1. Stock ABC has expected return of 13% and =1.5.The market expected return is 11% and rf = 5%. Acc. To CAPM which stock is a better buy? What is alpha of each stock? =E(r) { rf + [E(rm) rf] } XYZ =12-[5+ (11-5)] = 1% ABC = 13 [ 5+ 1.5(11-5)] =-1% ABC plots below SML ,while XYZ plots above

Question
The risk free rate is 8% and the expected return on market portfolio is 16%.A firm considers a project that is expected to have beta of 1.3.What is the required rate of return? If the expected IRR of the project is 19% , should it be accepted ?
=E(r) { rf + [E(rm) rf] }

= 8+1.3(16-8) =18.4%(Projects hurdle rate) Any project with an IRR equal to or less than 18.4 % should be rejected.

The Index Model and Realized Returns

To move from expected to realized returnsuse the index model in excess return form:

Ri = i + i RM + ei
Cov(Ri,Rm) = Cov (iRm+ei ,Rm) = i Cov(Rm,Rm)+ Cov (ei,Rm) =i 2M i = Cov(Ri,Rm) / 2M The index model beta coefficient turns out to be the same beta as that of the CAPM expected return-beta relationship

The CAPM and Reality

Is the condition of zero alphas for all stocks as implied by the CAPM met Not perfect but one of the best available Is the CAPM testable -The market portfolio is efficient -Alpha values are zero Proxies must be used for the market portfolio CAPM is still considered the best available description of security pricing and is widely accepted

The Economic validity of the CAPM

In regulated utilities for approving prices for providing fair return to shareholders In legal settings for finding the discount rates

Econometrics and the Expected ReturnBeta Relationship

It is important to consider the econometric technique used for the model estimated Statistical bias is easily introduced Miller and Scholes paper demonstrated how econometric problems could lead one to reject the CAPM even if it were perfectly valid Estimation of beta coefficients when residuals are correlated (GLS Vs.OLS) Alpha ,beta .residuals are time variant (ARCH)

Three Elements of Liquidity

Sensitivity of securitys illiquidity to market illiquidity:
Cov(Ci , CM ) L1 = Var ( RM CM )

Sensitivity of stocks return to market illiquidity: Cov( R , C )

L2 =
i M

Var ( RM CM )

Sensitivity of the security illiquidity to the market rate of return:

L3 =
Cov(Ci , RM ) Var ( RM CM )