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Single Index Model

Single Index Model

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Published by: asifanis on Jun 09, 2010
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04/09/2014

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Single Index Model
Prof Mahesh KumarAmity Business School
 
Introduction
According to Markowitz model of risk return optimizationIn Markowitz Model, to determine portfolio variance, pair wisecomparison of thousands of securities is to be done which is aformidable task.
The inherent problem in Markowitz Model is in the number of inputs required and the error in assessment or estimation of correlation coefficients.
If there are 50 securities in a portfolio, then input list willinclude:n=50 estimates of expected returnsn=50 estimates of variances(n
2
-n)/2=1225 estimates of co variances
SoSo eveneven forfor aa smallsmall portfolioportfolio of of 5050 securitiessecurities wewe requirerequire 13251325 estimatesestimates..
2222AABBABA,BAB
= w+ w + 2ww
 
Single Index Model-Assumptions
Known economist William Sharpe developed thesingle index model.
According to this model we make followingassumptions:a)We summarize all relevant economic factors by onemacro-economic indicator and assume that it movesthe security market as a whole.b)Beyond this common effect, all remaininguncertainty in stock return is firm specific; i.e. thereis no other source of correlation between securities.c)Stocks co vary together
onlyonly
because of theircommon relationship to the market index.

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