This action might not be possible to undo. Are you sure you want to continue?

SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

Assignment on SHARPE¶s SINGLE INDEX OR MAKET MODEL

Submitted To: Prof. Vardarajan

Submitted By: Faizaan Tughlaq (01) Nikhil Jirange (16)

Madhavi Parmar (38) Manzoor Parkar (39) Deepika Pawar (42)

Formally." One version of the model. and take expectations. uses a market index such as the S&P500 as the factor. The second assumption of the single-index model is that the idiosyncratic returns are independent across firms. any factor that influences security returns can serve as the index. In such a process. Individual responsiveness to the index is captured by the weight b1 . and is based on the assumption that the part of the return that is not explained by the index results from purely firm-specific events. This means that the covariance of ei and ej is zero. you will find that 2 . Recall. called the market model.Single-Index Model The major assumption of Sharpe's single-index model is that all the covariation of security returns can be explained by a single factor. Here. the single-index model assumes a one-factor returngenerating process. The single-index model assumes that we can write Here. Let ri be the return on stock i. although in principle. hence the name "single-index model. In particular. e is the idiosyncratic or residual or firm-specific return. This independence leads to a significant simplification of the covariance matrix of returns. that the covariance between the returns of i and j is If you substitute the equation multiply ri and rj. which means that it is the part not explained by the index. and let ri be the return on the index. we will adopt the terminology associated with the market model. the off-diagonal terms in the matrix take on a simple form. This factor is called the index. the variability of all stock returns can be completely described by one common index plus firm-specific events.

Since it is assumed that the unsystematic components are independent across firms. It is instructive to compare the above expression for portfolio variance with the objective function used in the full Markowitz problem: where the a's are the weights of individual securities in the portfolio. the variance is the sum of two components. the expression for the portfolio variance reduces to The portfolio problem then simplifies to subject to the weights summing to one. with 100 stocks. and 1 variance of the index in the single-index model. The first is the variance arising from the index. and resulting in a desired expected return. which is called the systematic risk. The second is the firm-specific or unsystematic risk. For example. You can see that there is a considerable saving in the number of terms contained in the single-index model compared to the full Markowitz formulation. the Markowitz problem has 10. the variance of ri reduces to: As you can see.000 (100x100) variances and covariances (of which only 5050 are distinct because the covariance matrix is symmetric). 100 residual variances. This compares to 100 betas.Similarly. 3 .

On a cautionary note. that the market portfolio in the CAPM is not the same as a "market index. the single-index model leads to a 4 . if you use a market index such as the S&P 500 in the single-index model." In fact. This will become readily apparent when you use the single-index model to analyze real-world data. you should remember first. in which case the covariance of returns is: This means that the covariance matrix in the single-index model has the security variance terms down the diagonal and the product of the beta and the variance of the index in the offdiagonal part. and if the index equals the market portfolio. If we take the expectation of ri in the single-index model and substitute we get This is the same functional form as in the CAPM. the result is exactly the same.Most of this simplification comes from the assumption that the unsystematic components are independent. you should remember that even though the functional form for the expected return is similar. To see this. There is a close relationship between the single-index model and the CAPM. since it is the point of tangency between the minimum variance frontier and the capital market line. The market portfolio is more appropriately called the tangency portfolio. it is quite unlikely that it will coincide with the tangency portfolio identified by the CAPM. recall that the CAPM implies where rM is the return on the market portfolio (see the two-fund theorem in Chapter 7). Second.

The topic Calculation of the Optimal Portfolio describes how the assumptions of the singleindex model allow you to quickly calculate optimal portfolio weights. 5 .simplification of the portfolio choice model because of the additional assumption that the idiosyncratic components of return are independent across stocks.

Sign up to vote on this title

UsefulNot useful- Central Limit Theoremby Yesar Bin Mustafa Almaleki
- Introduction to Stochastic Processesby Abolfazl Jalal Abadi
- International Journal of Scientific and Innovative Mathematical Research (IJSIMR)-3by International Journal of Scientific and Innovative Mathematical Research (IJSIMR)
- Chp6 Techniquesby Syed Tayyab

- Single Index Model
- Portfolio Theory- Sharpe Index Model
- Textbook Tutorial 05 Answers
- AP9211 Jan 2011
- GMM
- mat331_project1
- Psy524 Lecture 16 Discrim1
- Machine Learning
- IB Math HL Options Infinite Series Marathon
- The Arrangements of Tubular Form is Given by Assignment 2011
- STLFSI
- Lec 2
- Winitzki - Approximation to Error Function
- QuadEquations_PPT_Alg2
- Realized Skewness11
- Steepest Descent Adaptive Filter
- MEC 325-Home Work#1
- lect05
- Non Linear Systems
- Haas
- Central Limit Theorem
- Introduction to Stochastic Processes
- International Journal of Scientific and Innovative Mathematical Research (IJSIMR)-3
- Chp6 Techniques
- Chapt19 multicollinearity
- Svm Tutorial
- Probability Basic Outline of stuff to learn
- Correlation
- sec33b
- 1007.4063
- Sharpe Single Index

Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

We've moved you to where you read on your other device.

Get the full title to continue

Get the full title to continue reading from where you left off, or restart the preview.

scribd