Index Models

The Single Index Model

Advantages: Reduces the number of inputs for diversification Easier for security analysts to specialize Drawback: the simple dichotomy rules out important risk sources (such as industry events)

Single Factor Model

ri E( Ri) iF ei
i = index of a securitys particular return to the
factor F= some macro factor; in this case F is unanticipated movement; F is commonly related to security returns

Single Index Model

(ri rf ) ai i(rM rf ) ei

ai = stocks expected return if

markets excess return is zero
due to market movements

i(rM-ri) = the component of return

ei = the component of return due to unexpected firm-specific events

Risk Premium Format

Let: Ri = (ri - rf ) Risk premium format

Rm = (rm - rf )

Ri = ai + iRm + ei

Components of Risk
Market or systematic risk: risk related to the macro economic factor or market index Unsystematic or firm specific risk: risk not related to the macro factor or market index Total risk = Systematic + Unsystematic

Measuring Components of Risk

i i M (ei )
2 2 2 2

i2 = total variance i2 m2 = systematic variance 2(ei) = unsystematic variance

Examining Percentage of Variance

2 2 M

(e)

Total Risk = Systematic +Unsystematic

R square

2 i

2 M 2

2 (ei ) 2 1 2

Security Characteristic Line

Excess Returns (i) . . . . . . . . . . . . . . . . . SCL . .

. .. .. .. . . . . . .. . . . . .

. .

.
. . .
i

Excess returns .on.market index

Ri =

+ iRm + ei

Example
Excess X Returns 5.41 3.44 . 2.43 -0.60 4.97 Excess Mkt Returns 7.24 0.93 . 3.90 1.75 3.32

January February . December Mean Std Deviation

Regression Results
rXYZ rf a (rM rf )
a
Estimated coefficient -2.590

1.1357

Std error of estimate

(1.547)

(0.309)

Variance of residuals = 12.601 Std dev of residuals = 3.550 R-SQR = 0.575

Industry Prediction of Beta

BMO Nesbitt Burns and Merrill Lynch examples
BMO NB uses returns not risk premiums a has a different interpretation: a + rf (1-) Merill Lynchs adjusted

Forecasting beta as a function of past beta Forecasting beta as a function of firm size, growth, leverage etc.