CHAPTER 8

Index Models

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Advantages of the Single Index
Model
• Reduces the number of inputs for
diversification

• Easier for security analysts to specialize

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 Single Factor Model

ri E (ri ) i m ei
βi = response of an individual security’s return to
the common factor, m. Beta measures systematic
risk.
m = a common macroeconomic factor that affects
all security returns. The S&P 500 is often used as a
proxy for m.
ei = firm-specific surprises
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 Single-Index Model
• Regression Equation:
Ri t i i RM t ei t
• Expected return-beta relationship:

E Ri i i E RM

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 Single-Index Model

• Risk and covariance:

– Variance = Systematic risk and Firm-specific
risk:
2 2 2 2
i i M (ei )

– Covariance = product of betas x market

index risk:
2
Cov(ri , rj ) i j M

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 Single-Index Model

• Correlation = product of correlations with the

market index

2 2 2
i j M i M j M
Corr (ri , rj ) Corr (ri , rM ) xCorr (rj , rM )
i j i M j M

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Index Model and Diversification
• Variance of the equally weighted portfolio of
firm-specific components:
n 2
2 1 2 1 2
(eP ) (ei ) (e)
i 1 n n

• When n gets large, σ2(ep) becomes negligible and

firm specific risk is diversified away.

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Figure 8.1 The Variance of an Equally Weighted
Portfolio with Risk Coefficient βp

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Figure 8.3 Scatter Diagram of HP, the S&P 500,
and HP’s Security Characteristic Line (SCL)

RHP t HP HP RS &P500 t eHP t

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Table 8.1 Excel Output: Regression
Statistics for the SCL of Hewlett-
Packard

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 Table 8.1 Interpretation

• Correlation of HP with the S&P 500 is 0.7238.

• The model explains about 52% of the variation in HP.
• HP’s alpha is 0.86% per month(10.32% annually) but
it is not statistically significant.
• HP’s beta is 2.0348, but the 95% confidence interval
is 1.43 to 2.53.

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 Alpha and Security Analysis
1. Use macroeconomic analysis to estimate the risk
premium and risk of the market index.

2. Use statistical analysis to estimate the beta

coefficients of all securities and their residual
variances, σ2 (ei).

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 Alpha and Security Analysis

3. Establish the expected return of each security

absent any contribution from security analysis.

4. Use security analysis to develop private forecasts

of the expected returns for each security.

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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

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Figure 8.5 Efficient Frontiers with the
Index Model and Full-Covariance
Matrix

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Table 8.2 Portfolios from the Single-
Index and Full-Covariance Models

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 Beta Book: Industry Version of the
Index Model

• Use 60 most recent months of price data

• Use S&P 500 as proxy for M
• Compute total returns that ignore dividends
• Estimate index model without excess returns:

*
r a brm e
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Beta Book: Industry Version of the
Index Model

• The average beta over all

securities is 1. Thus, our
best forecast of the beta
Adjust beta would be that it is 1.
because:
• Also, firms may become
more “typical” as they age,
causing their betas to
approach 1.
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Table 8.4 Industry Betas and
Adjustment Factors

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 Chapter Nine

The Capital Asset

Pricing Model

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Capital Asset Pricing Model (CAPM)
• CAPM is a set of predictions concerning
equilibrium expected returns on risky assets
• Based on two sets of assumptions
• Individual behavior
• Market structure
• Markowitz established modern portfolio
management in 1952
• Sharpe, Lintner and Mossin published CAPM
in 1964
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Assumptions

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 The Market Portfolio

• All investors will hold the same portfolio for

risky assets — market portfolio

• Market portfolio contains all securities

• Proportion of each stock in this portfolio equals
the market value of the stock (price per share
times number of shares outstanding) divided by
the sum of the market value of all stocks

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Capital Allocation Line

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Capital Market Line

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 The Risk Premium of the Market
Portfolio
• The market risk premium is proportional to its
risk and the degree of risk aversion:
2
E ( RM ) A M

Where
A representative investor’s risk aversion
2
M
variance of the market portfolio

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 Expected Returns on Individual
Securities
• CAPM is build on the insight that the
appropriate risk premium on an asset will be
determined by its contribution to the risk of
investors’ overall portfolios
• All investors use the same input list (i.e., they all
end up using the market as their optimal risky
portfolio)

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 Individual Securities:
Example
• Covariance of GE return with the market
portfolio:
n n
wi Cov( Ri , RGE ) Cov wi Ri , RGE
i 1 i 1

• The reward-to-risk ratio for GE would be:

GE's contribution to risk premium E ( RGE )
GE's contribution to variance Cov( RGE , RM )

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 GE Example
(1 of 2)

• Reward-to-risk ratio for investment in market

portfolio (i.e., market price of risk):
Market risk premium E ( RM )
2
Market variance ( RM )

• Equilibrium dictates all investments should

offer the same reward-to-risk ratio
E ( RGE ) E ( RM )
2
Cov( RGe , RM ) ( RM )

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 GE Example
(2 of 2)

• Fair risk premium for GE stock:

Cov( RGe , RM )
E ( RGE ) 2
E ( RM )
( RM )

• Restating, we obtain:

E rGE rf GE E rM rf

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 Expected Return-Beta Relationship

• Expected return-beta relationship tells us the

total expected rate of return is the sum of the
risk-free rate plus a risk premium
• Risk premium is the product of a “benchmark risk
premium” and the relative risk of the particular
asset as measured by its beta

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The Security Market Line

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The SML and a Positive-Alpha Stock

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 The CAPM and the Single-Index
Market
• Index model states the realized excess return on
any stock is the sum of the following:
• Realized excess return due to marketwide factors
• A nonmarket premium
• Firm-specific outcomes

Ri i i RM ei
• The index model beta coefficient is the same as
the beta of the CAPM expected return-beta
relationship
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 Liquidity Risk

• In a financial crisis, liquidity can unexpectedly

dry up
• When liquidity in one stock decreases, it
commonly tends to decrease in other stocks at
the same time
• Investors demand compensation for liquidity
risk, demonstrated by firms with greater
liquidity risk having higher average returns
• “Liquidity betas”
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 The CAPM and Academic World
• Testing the CAPM is surprisingly difficult
• Cannot observe all tradable assets
• Impossible to pin down market portfolio
• Both alpha and beta, as well as residual variance,
are likely time varying

• Most tests of the CAPM are directed at the

mean-beta relationship as applied to assets
with respect to an observed, but perhaps
inefficient, stock index portfolio
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The CAPM and Investment Industry

• Portfolio theory and the CAPM have become

accepted tools in the practitioner community
• Many professionals are comfortable with the use
of beta to measure systematic risk
• Most investors don’t beat the index portfolio

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