Investments, 8

th
edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 8
Index Models
8-2
Reduces the number of inputs for
diversification
Easier for security analysts to specialize
Advantages of the Single Index Model
8-3

i
= index of a securities particular return to the
factor
m = Unanticipated movement related to security
returns
e
i
= Assumption: a broad market index like the
S&P 500 is the common factor.
Single Factor Model
( )
i i i i
r E r m e | = + +
8-4
Single-Index Model
Regression Equation:


Expected return-beta relationship:




( ) ( ) ( )
t i t M i
R t R t e t o | = + +
( ) ( )
i i i M
E R E R o | = +
8-5
Single-Index Model Continued
Risk and covariance:
Total risk = Systematic risk + Firm-specific
risk:
Covariance = product of betas x market index
risk:

Correlation = product of correlations with the
market index
2 2 2 2
( )
i i M i
e o | o o = +
2
( , )
i j i j M
Cov r r | | o =
2 2 2
( , ) ( , ) ( , )
i j M i M j M
i j i M j M
i j i M j M
Corr r r Corr r r xCorr r r
| | o | o | o
o o o o o o
= = =
8-6
Index Model and Diversification
Portfolios variance:


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


When n gets large, becomes
negligible
2
2
2 2
1
1 1
( ) ( ) ( )
n
P i
i
e e e
n n
o o o
=
| |
= =
|
\ .

2 2 2 2
( )
P P M P
e o | o o = +
2
( )
P
e o
8-7
Figure 8.1 The Variance of an Equally
Weighted Portfolio with Risk Coefficient

p
in the Single-Factor Economy
8-8
Figure 8.2 Excess Returns on HP and
S&P 500 April 2001 March 2006
8-9
Figure 8.3 Scatter Diagram of HP, the
S&P 500, and the Security Characteristic
Line (SCL) for HP
8-10
Table 8.1 Excel Output: Regression
Statistics for the SCL of Hewlett-Packard
8-11
Figure 8.4 Excess Returns on Portfolio
Assets
8-12
Alpha 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 )
Developed from security analysis
8-13
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

8-14
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
8-15
Optimal Risky Portfolio of the Single-
Index Model
Maximize the Sharpe ratio
Expected return, SD, and Sharpe ratio:
1 1
1 1
1
2
2 1
1 1
2 2 2 2 2 2
2
1 1
( ) ( ) ( )
( ) ( )
( )
n n
P P M P i i M i i
i i
n n
P P M P M i i i i
i i
P
P
P
E R E R w E R w
e w w e
E R
S
o | o |
o | o o o | o
o
+ +
= =
+ +
= =
= + = +
(
| |
(
= + = + (
|

\ . (

=


8-16
Optimal Risky Portfolio of the Single-
Index Model Continued
Combination of:
Active portfolio denoted by A
Market-index portfolio, the (n+1)th asset
which we call the passive portfolio and
denote by M
Modification of active portfolio position:


When

0
*
0
1 (1 )
A
A
A A
w
w
w |
=
+
* 0
1,
A A A
w w | = =
8-17
The Information Ratio
The Sharpe ratio of an optimally constructed
risky portfolio will exceed that of the index
portfolio (the passive strategy):
2
2 2
( )
A
P M
A
e
s s
o
o
(
= +
(

8-18
Figure 8.5 Efficient Frontiers with the
Index Model and Full-Covariance Matrix
8-19
Table 8.2 Comparison of Portfolios from
the Single-Index and Full-Covariance
Models
8-20
Table 8.3 Merrill Lynch, Pierce, Fenner &
Smith, Inc.: Market Sensitivity Statistics
8-21
Table 8.4 Industry Betas and Adjustment
Factors