Topic04 - Markowitz and SIM

FIE400E - Investments
Topic 4 - Markowitz and Single-Index Model
Francisco Santos
Norwegian School of Economics

Outline
Markowitz portfolio selection model

Single-index model
Readings: BKM, chapters 7-8
Francisco Santos (NHH) FIE400E - Investments 1 / 40

Capital Allocation Across Two Risky Portfolios and a
Risk-Free Asset
Recipe
1 Specify the return characteristics of all securities:

I Expected returns, variances and covariances.
2 Determine the optimal risky portfolio – Tangent Portfolio (TP):

E [rP ]−rF P
I maxwi SP = σP subject to i wi = 1
E [RB ]σS2 − E [RS ]σB,S

wB ∗ =
E [RS ]σB2 + E [RB ]σS2 − (E [RS ] + E [RB ])σB,S
wS ∗ = 1 − wB ∗
I where RB = rB − rF and RS = rS − rF

Capital Allocation Across Two Risky Portfolios and a
Risk-Free Asset
Recipe
3 Determine the properties of the optimal risky portfolio TP:

I E [rTP ] = wB E [rB ] + wS E [rS ]
2
I σTP = wB2 σB2 + wS2 σS2 + 2wB wS σB,S
I Use the weights from step 2.
4 Allocate funds between the risky portfolio TP and the risk-free asset.
I With U = E [r ] − 0, 5Aσ 2 , the fraction of the complete portfolio
allocated to the risky portfolio TP is given by:
E [rTP ] − rF
y∗ = 2
AσTP

The Markowitz Portfolio Selection Model
We can generalize the previous results to the case of many risky

securities and a risk-free asset.
We start by determining the risk-return opportunities available to the

investor.
Then we draw the minimum-variance frontier:

I graph of the lowest possible variance that can be obtained for a given
expected return.


Note that all individual assets lie inside the frontier (this is true when
we allow for short-selling).
This implies that risky portfolios of only one single asset are
inefficient.
The part of the minimum-variance frontier above the global

minimum-variance portfolio is called the efficient frontier of risky
assets.
The optimal portfolio lies on the efficient frontier of risky assets.

The next step is to add the risk-free asset to the optimization

problem.
As in the case of two risky portfolios, the optimal portfolio will be the
portfolio with highest Sharpe-ratio (the steepest slope).
The CAL that is supported by the optimal portfolio, TP, is tangent to

the efficient frontier.
Portfolios on the CAL(TP) dominate all alternative feasible lines.


The last part of the optimization problem is to choose the appropriate

mix between the optimal risky portfolio TP and the risk-free asset.
With U = E [r ] − 0, 5Aσ 2 , the fraction of the complete portfolio

allocated to the risky portfolio TP is given by:
E [rTP ] − rF
y∗ = 2
AσTP

Capital Allocation and the Separation Principle
The separation property: the portfolio choice problem may be

separated into two independent tasks:
1 Determination of the optimal risky portfolio.
2 Allocation of the complete portfolio to the risk-free asset and the
optimal risky portfolio.
The crucial point is that a portfolio manager will offer the same risky
portfolio, TP, to all clients.
The degree of risk aversion comes into play only in the selection of
the desired point along the CAL(TP).

Potential problems with the Markowitz Model
To find the optimal risky portfolio TP using the Markowitz model we

need a high amount of input data.
For n stocks we need:

I n estimates of expected returns;
I n estimates of variances;
n(n−1)
I
2 estimates of covariances.
If n = 3.000, then we need 4.504.500 estimates.

Potential problems with the Markowitz Model
There is an additional problem when the estimates of the correlation

matrix are mutually inconsistent.
Example:
Correlation Matrix
Asset σ
A B C
A 20% 1
B 20% 0,90 1
C 20% 0,90 0 1
Suppose you construct a portfolio with weights

wA = −100%, wB = 100%, wC = 100%.
The variance of this portfolio is -0,024 – variances cannot be negative!

Alternatives to the Markowitz Model
Due to the problems with the Markowitz model others were

developed.
For example:
I Single-Index Model – SIM
I Capital Asset Pricing Model – CAPM

Single-Index Model
SIM as a Single-Factor Model
The Single-Index Model is an example of a single-factor model.
A single-factor model assumes that the realized return of security i is

given by:
ri = E [ri ] + βi m + ei
I E [ri ] is the expected value of the return on security i;

I m and ei are random variables;
I ei measures firm-specific surprises; unexpected return due to
firm-specific factors;
I m is a macroeconomic factor that measures unanticipated macro
surprises/shocks;
I βi measure the sensitivity of firm i to macro shocks.

Single-Index Model
The realized rate of return is the sum of its expected plus

unanticipated components.
Note that the unexpected value ei differs for each security i, whereas
m is a common factor for all securities.
It is a single-factor model because there is only one common factor.
Note that this structure of returns is an assumption – we do not know

if this is the true one.
So, relative to Markowitz it requires stronger initial assumptions.

Single-Index Model
It actually has some more assumptions:

I m and ei are normally distributed with mean 0 and standard deviations
of σm and σei , respectively.
I Firm-specific surprises ei are assumed to be uncorrelated across firms:

Cov (ei , ej ) = 0 for i 6= j.
I m is uncorrelated with any of the firm-specific surprises:

Cov (m, ei ) = 0.

Single-Index Model
The variance of ri thus arises from two uncorrelated sources,

systematic and unsystematic:
σi2 = βi2 σm
2
+ σe2i
“Cyclical” firms (high β) have greater sensitivity to the market and

therefore higher systematic risk.
The covariance of returns between any two securities i and j is:

2
Cov (ri , rj ) = Cov (E [ri ] + βi m + ei , E [rj ] + βj m + ej ) = βi βj σm

Single-Index Model
How to make this single-factor model operational?

Use the rate of return on a broad index of securities such as S&P 500
as a proxy for the common macroeconomic factor – Single-Index
model.
Write a regression equation:
ri,t − rf ,t = αi + βi [rm,t − rf ,t ] + ei,t
I where t denotes the date of each pair of observations

I We can also write this in terms of excess returns:
Ri,t = αi + βi Rm,t + ei,t

Single-Index Model a = mispricing
Ri,t = αi + βi Rm,t + ei,t
Taking expectations:
E [Ri,t ] = E [αi + βi Rm,t + ei,t ] = αi + βi E [Rm ]
Risk premium of security i equals the sum of αi and βi E [Rm ].
Alpha is a nonmarket premium:

I α may be large/small if you think a security is underpriced/overpriced.
I Managers who claim to do a superior job of security analysis = they
believe that they are able to find stocks with nonzero alpha.
I In equilibrium, α = 0 because attractive opportunities ought to be
competed away.
The second term of the equation tells us that part of a security’s risk
premium is due to the risk premium of the index.
Single-Index Model
SIM and Diversification
Suppose we choose an equally weighted portfolio (P) of n securities.
The excess rate of return on each security is given by:
Ri = αi + βi Rm + ei
The excess rate of return on the portfolio is given by:

n n
X 1X
RP = w i Ri = Ri
n
i=1 i=1
n
1X
= (αi + βi Rm + ei )
n
i=1
n n n
1X 1X 1X
= αi + βi Rm + ei
n n n
i=1 i=1 i=1
= αP + βP Rm + eP

Single-Index Model
The variance of the portfolio is given by:
σP2 = βP2 σm
2
+ σe2P
At first glance, it seems that we still have portfolio idiosyncratic risk

(σe2P ).
However, what is σe2P ?

n n
!
1X 1 X 1
σe2P = Var ei = 2 σei = σ¯e2
n n n
i=1 i=1
Where σ¯e2 is the average of the firm-specific variances.
When n becomes large, σe2P becomes negligible – diversification.

Single-Index Model

Single-Index Model
Estimating the SIM
We regress the excess return of a security, Ri , on the excess return of

the index, Rm .
To estimate the regression, we collect a historical sample of paired

observations, Ri,t and Rm,t , where t denotes the date of each pair of
observations.

Single-Index Model
Estimating the SIM
Example:

Single-Index Model
Estimating the SIM
Example:

Single-Index Model
Estimating the SIM
Example:
|tstat| > 1,96 significant

p value < 0,05 significant

Single-Index Model
Estimating the SIM
Example:
Alpha=2,653%, but it is not statistically significant from zero
(p − value > 5%).
Beta=1,369 and statistically significant different from zero.
Is this beta statistically significant different from 1? No.

Estimated Value − Hypothesized Value 1, 369 − 1
= =1<2
Standard Error 0, 369
√
Firm-specific risk: 7.94% per month ( 12 × 7, 94% = 27, 5%
annually).

Single-Index Model
Estimating the SIM
The set of estimates needed for the single-index model:

For n stocks we need:
I n estimates of αi ;
I n estimates of βi ;
I n estimates of firm-specific variance σe2i ;
2
I 1 estimate of the market factor variance σm ;
I 1 estimate of E [Rm ].
This amounts to 3n + 2 estimates.
If n = 3.000, then we need 9.002 estimates (as opposed to the

4.504.500 estimates for the Markowitz model).

The Optimal Risky Portfolio of the Single-Index Model
One way to find the optimal risky portfolio is by maximizing the

Sharpe ratio.
Note that the investor has n securities plus the index portfolio as
options to invest.
Hence, the objective is to find optimal weights w1 , ..., wn+1 such that
the Sharpe ratio is maximized.

n+1
X n+1
X
E [RP ] = wi αi + E [Rm ] wi βi
i=1 i=1
 !2 0,5
n+1
X n+1
X
σP = (βP2 σm
2
+ σe2P )0,5 = σm
2
wi βi + wi2 σe2i 
i=1 i=1
E [RP ]
max SP =
w1 ,...,wn+1 σP

The optimal risky portfolio turns out to be a combination of two

portfolios:
1 An active portfolio, A, comprised of the n analyzed securities. We call
this the active portfolio because it follows from active security analysis.
2 A passive portfolio, i.e., the market index.
more active portfolio cuz of more willingness for more bets
E [RP ] = αP + βP E [Rm ]
Rp = rm-rf
every sec different a
n
X n
X
E [RP ] = wi αi + E [Rm ] wi βi + E [Rm ]wn+1
i=1 i=1
E(Rm+1) = 0 + 1 *Rm simga^21 = ß1^2*simga^2m + simga^2e1
sigma ^2m = sigma^2m

There is a trade-off between the active and passive portfolios.
If we only want diversification, than we should hold only the market

index.
Security analysis gives us the chance to uncover securities with a

nonzero alpha and to take a position in those securities.
This position comes at a cost – departure from efficient diversification

(unnecessary firm-specific risk).
The model shows us that the optimal risky portfolio trades off the
search for alpha against the departure from efficient diversification.

10-Steps recipe for the optimal risky portfolio
1 Compute the initial position of each security in the active portfolio:
αi
wi0 = 2
σei
2 Scale those initial positions to force the portfolio weights to sum to 1
by dividing by their sum:
w0
wi = Pn i 0
i=1 wi
3 Compute the alpha of the active portfolio:
Xn
αA = wi αi
i=1
4 Compute the residual variance of the active portfolio:
Xn
2
σeA = wi2 σe2i
i=1

5 Compute the initial position in the active portfolio:
αA
σe2
wA0 = A
E [Rm ]
2
σm
6 Compute the beta of the active portfolio:

n
X
βA = wi βi
i=1
7 Adjust the initial position of the active portfolio:
wA0
wA∗ =
1 + (1 − βA )wA0
8 The optimal portfolio has weights:
∗
wm = 1 − wA∗ and wi∗ = wA wi
9 Compute the risk premium of the optimal portfolio:
E [RP ] = wA∗ αA + E [Rm ](wm

∗
+ wA∗ βA )
I Note that the beta of the risky portfolio is (wm∗ + wA βA ) because the
beta of the index portfolio is 1.
10 Compute the variance of the optimal risky portfolio:
σP2 = (wA∗ σeA )2 + σm

2 ∗
(wm + wA∗ βA )2
I Compute the Sharpe ratio of the optimal risky portfolio:

F If SP > Sm then P is indeed the optimal risky portfolio.
F If SP < Sm then there is no optimal risky portfolio.

Information ratio
The Sharpe ratio of an optimally constructed risky portfolio will

exceed that of the index portfolio:
appraisal
ratio 2
αA
SP2 = Sm
2
+
σeA
The contribution of the active portfolio (when held in its optimal
weight) to the overall Sharpe Ratio is determined by the ratio of its
alpha to its residual standard deviation – this ratio is called the
information ratio.

Information ratio
It can be shown that:

2 n
αi 2

αA X
=
σeA σei
i=1
The contribution of the each security to the information ratio of the

active portfolio depends on its own information ratio.
This reveals the central role of the information ratio in efficiently
taking advantage of security analysis:
I Positive side: alpha
I Negative side: firm-specific risk.

Example
firmspecific
Security Alpha Beta σei σm E [Rm ]

1 2% 1,2 6% - -
2 3% 1,1 8% - -
Market - 1 - 7,6% 6%
10-steps recipe:
0,02 0,03
1 w10 = 0,062 = 5, 5555 w20 = 0,082 = 4, 6875
5,5555 4,6875
2 w1 = 5,5555+4,6875 = 54, 24% w2 = 5,5555+4,6875 = 45, 76%
3 αA = 54, 24% × 2% + 45, 76% × 3% = 2, 46%
4 σe2A = 54, 24%2 × 6%2 + 45, 76%2 × 8%2 = 0, 0024

Example
2,46% 6%
5 wA0 = 0,0024 / 7,6%2 = 0, 986
6 βA = 54, 24% × 1, 2 + 45, 76% × 1, 1 = 1, 154

0,986
7 wA ∗ = 1+(1−1,154)0,986 = 116%
8 wm∗ = 1 − 116% = −16%,

w1∗ = 116% × 54, 24% = 63, 07%,
w2∗ = 116% × 45, 76% = 53, 22%
9 E [RP ] = 1, 16 × 2, 46% + (−0, 16 + 1, 16 × 1, 154)6% = 9, 934%

p
10 σP = (−0, 16 + 1, 16 × 1, 154)2 7, 6%2 + 1, 162 × 0, 0024 = 10, 62%

Example
Checking if it is really an optimal portfolio:

9,934% 6%
I SP = 10,62% = 0, 935 > 0, 789 = 7,60% = Sm ⇒ P is indeed optimal.
Checking the information ratio relations:

2
αA
I SP2 = Sm2 + σeA
2
F 0, 9352 = 0, 7892 + √2,46% ⇔ 0, 875 = 0, 875
0,0024
2 Pn 2
αA αi
I
σeA = i=1 σei
2
√2,46% 2% 2 3% 2

F
0,0024
= 6%
+ 8%
⇔ 0, 252 = 0, 252
Mehrere sec --> mehr investieren mit höherem alpha, negative alphas shorten, mehr shorten wenn alpha per unit of firm
specific risk is better, 0 a,pha ~ market therefore 0 weight

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FIE400E - Investments

Topic 4 - Markowitz and Single-Index Model

Norwegian School of Economics

Markowitz portfolio selection model

Readings: BKM, chapters 7-8

Francisco Santos (NHH) FIE400E - Investments 1 / 40

1 Specify the return characteristics of all securities:

2 Determine the optimal risky portfolio – Tangent Portfolio (TP):

E [RB ]σS2 − E [RS ]σB,S

Francisco Santos (NHH) FIE400E - Investments 2 / 40

3 Determine the properties of the optimal risky portfolio TP:

I Use the weights from step 2.

Francisco Santos (NHH) FIE400E - Investments 3 / 40

We can generalize the previous results to the case of many risky

We start by determining the risk-return opportunities available to the

Then we draw the minimum-variance frontier:

Francisco Santos (NHH) FIE400E - Investments 4 / 40

Francisco Santos (NHH) FIE400E - Investments 5 / 40

The part of the minimum-variance frontier above the global

The optimal portfolio lies on the efficient frontier of risky assets.

Francisco Santos (NHH) FIE400E - Investments 6 / 40

The next step is to add the risk-free asset to the optimization

The CAL that is supported by the optimal portfolio, TP, is tangent to

Portfolios on the CAL(TP) dominate all alternative feasible lines.

Francisco Santos (NHH) FIE400E - Investments 7 / 40

Francisco Santos (NHH) FIE400E - Investments 8 / 40

The last part of the optimization problem is to choose the appropriate

With U = E [r ] − 0, 5Aσ 2 , the fraction of the complete portfolio

Francisco Santos (NHH) FIE400E - Investments 9 / 40

The separation property: the portfolio choice problem may be

Francisco Santos (NHH) FIE400E - Investments 10 / 40

To find the optimal risky portfolio TP using the Markowitz model we

For n stocks we need:

If n = 3.000, then we need 4.504.500 estimates.

Francisco Santos (NHH) FIE400E - Investments 11 / 40

There is an additional problem when the estimates of the correlation

Suppose you construct a portfolio with weights

The variance of this portfolio is -0,024 – variances cannot be negative!

Francisco Santos (NHH) FIE400E - Investments 12 / 40

Due to the problems with the Markowitz model others were

I Capital Asset Pricing Model – CAPM

Francisco Santos (NHH) FIE400E - Investments 13 / 40

The Single-Index Model is an example of a single-factor model.

A single-factor model assumes that the realized return of security i is

I E [ri ] is the expected value of the return on security i;

Francisco Santos (NHH) FIE400E - Investments 14 / 40

The realized rate of return is the sum of its expected plus

It is a single-factor model because there is only one common factor.

Note that this structure of returns is an assumption – we do not know

So, relative to Markowitz it requires stronger initial assumptions.

Francisco Santos (NHH) FIE400E - Investments 15 / 40

It actually has some more assumptions:

I Firm-specific surprises ei are assumed to be uncorrelated across firms:

I m is uncorrelated with any of the firm-specific surprises:

Francisco Santos (NHH) FIE400E - Investments 16 / 40

The variance of ri thus arises from two uncorrelated sources,

“Cyclical” firms (high β) have greater sensitivity to the market and

The covariance of returns between any two securities i and j is:

Francisco Santos (NHH) FIE400E - Investments 17 / 40

How to make this single-factor model operational?

Write a regression equation:

ri,t − rf ,t = αi + βi [rm,t − rf ,t ] + ei,t

I where t denotes the date of each pair of observations

Ri,t = αi + βi Rm,t + ei,t

E(Rm+1) = 0 + 1 Rm simga^21 = ß1^2simga^2m + simga^2e1