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Single Index Model and Market Model - Jose Marin

# Single Index Model and Market Model - Jose Marin

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Difference between single index model and market model.
Difference between single index model and market model.

Published by: johnolavin on Oct 23, 2013

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10/23/2013

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Market and Index Models Session 08Copyright
José M. Marín Portfolio Management1
Outline 08: Market and Index Models
1.

CAPM and Multifactor Models2.

Bloomberg Screen3.

Components of Variance4.

Diversification Effects5.

Precision of Historical Betas6.

Estimating Expected Returns8.

Market-Neutral Strategies (Problem Set)
Mandatory Reading: Hansell´s article.
CAPM and Multifactor Models

In the previous section we saw that in a CAPM framework the only variable that matters for asset pricing is the return of the market portfolio.

Consider the following statistic representation of asset returns:
( )
new informationexpected component
innovation in 's return
j j
R E R j
= +
14444244443123

We can also distinguish two broad types of innovations: systematic (generated by an arbitrarily large setof factors,
) and idiosyncratic.
( )
{
1122idiosyncratic innovationsystematic innovation( )( )
....
j j j j jK K junique risk aggregate risk factors
R E R F F
β β β ε
= + + + + +
1444442444443

We end up with the following linear factor model of asset returns:
1122
....
j j j j jK K j
R a F F
β β β ε
= + + + + +

Market and Index Models Session 08Copyright
José M. Marín Portfolio Management2

Now we can interpret the CAPM as a model in which returns are generated by a single factor:
1122
....
j
j j j j jK K j R
R a F F
β
β β β ε
= + + + + +
1444442444443

More specifically, the
Market Model
1

is defined as:
j j j M j
R a R
β ε
= + +
,
j = 1, …, N

0,
j M j
E R E j
ε ε
= =

0
i j
E
ε ε
=

This is, for instance, the model used by Bloomberg.
1
The label
market model
is often used for a model in which only (1) and (2) hold and the term
single index model
for the model in which (3) also holds. We will just use thelatter.

Market and Index Models Session 08Copyright