FINM7008

APPLIED INVESTMENTS
INDEX MODELS
Qiaoqiao Zhu
ANU 2022 S2

1
 OUTLINE
implications of portfolio theory for the expected
returns on risky assets in equilibrium.
Drawbacks to Markowitz procedure
Today, we will discuss single factor models of
risk and return such as index models;
These models are a prelude to the Capital
Asset Pricing Model (“CAPM”)

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MARKOWITZ'S PORTFOLIO
SELECTION
Last lecture, we discussed the formation of risky
portfolios based on the expected return and risk of
the constituent assets. In doing this, we noted that
portfolio risk is a function of:
The weight in which each asset is held; and,
The covariance of the returns on pairs of assets
forming part of the portfolio.
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MARKOWITZ'S PORTFOLIO
SELECTION
Drawbacks to Markowitz procedure
Requires a huge number of estimates to fill the
covariance matrix
n expected returns;
n variances; and,
(𝑛 − 𝑛)/2 covariances.
2

Model does not provide any guidelines for

finding useful estimates of these covariances
or the risk premiums 4
ALTERNATIVE APPROACH
Stipulating the manner in which security returns
are generated
Simplify how we describe sources of risk; and,
Reduce the computational effort associated
with Markowitz’s model.

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SINGLE-FACTOR SECURITY
MARKETS
Decompose actual rate of return by a given
security i into an expected (𝔼(𝑟 ) ) and unexpected
𝑖

component (𝜖 ), 𝑖

𝑟 𝑖 = 𝔼(𝑟 𝑖 ) + 𝜖𝑖

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SINGLE-FACTOR SECURITY
MARKETS
We can decompose the unexpected component of
security i’s returns into that stemming from a
macroeconomic factor, 𝑚 , with sensitivity 𝛽 , and
𝑖

the result of firm-level surprises

𝑟 𝑖 = 𝔼(𝑟 𝑖 ) + 𝛽𝑖 𝑚 + 𝑒𝑖

Importantly, the expected value 𝔼(𝑚) and 𝔼(𝑒 ) are

𝑖

zero, 𝑚 , 𝑒 and 𝑒 are uncorrelated.

𝑖 𝑗

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SINGLE-FACTOR SECURITY
MARKETS
we can now decompose the variance of 𝑟 𝑖

2 2 2 2
𝜎 = 𝛽 𝜎𝑚 + 𝜎 (𝑒𝑖 )
𝑖 𝑖

covariance between the returns on securities 𝑖, 𝑗 :

2
𝑐𝑜𝑣(𝑟 𝑖 , 𝑟 𝑗 ) = 𝑐𝑜𝑣(𝛽𝑖 𝑚 + 𝑒𝑖 , 𝛽𝑗 𝑚 + 𝑒𝑗 ) = 𝛽𝑖 𝛽𝑗 𝜎𝑚

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 SINGLE-FACTOR MODEL
An obvious question is how we measure the
unexpected macroeconomic factor, 𝑚 .
One approach is to use the rate of return on a
broad index of securities, M, as a proxy for this
factor;
In Australia, we might use the ASX All Ordinaries
Index and, in the US, we could utilise the S&P500
index;
Such a model is called the Single-Index model.
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 SINGLE-FACTOR MODEL
Using historical data and regression analysis we
can estimate the sensitivity of asset i to systematic
risk by performing the following regression:
𝑅𝑖𝑡 = 𝛼 𝑖 + 𝛽𝑖 𝑅𝑀 + 𝑒𝑖𝑡

where 𝑅 and 𝑅 are the security’s excess

𝑖𝑡 𝑀

return and the market’s excess return,

respectively.
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 SINGLE-FACTOR MODEL
If we take the expected value of 𝑅 in the equation,
𝑖

because 𝔼(𝑒 ) = 0, we get expected return-beta

𝑖𝑡

relationship for the single-index model:

𝔼(𝑅𝑖𝑡 ) = 𝛼 𝑖 + 𝛽𝑖 𝔼(𝑅𝑀 )

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 SINGLE-FACTOR MODEL
Using historical data to estimate the single-index
model yields the Security Characteristic Line
(SCL). Here:
The intercept is the asset’s alpha for the sample
period;
The slope represents the beta of the asset;
The error terms represent the difference
between actual returns and those predicted by
the regression line, or the unexpected firm-
specific component of the return.
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SINGLE-FACTOR MODEL
(SCL)

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SINGLE-FACTOR MODEL

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 SINGLE-FACTOR MODEL
Yields a value of beta, which is helpful in
estimating future systematic risk.
Also yields a value of alpha, however, we would
not use it as a forecast for future alpha.
estimates from successive periods can revert
Instead, analysts must use security analysis to
develop their expectation regarding future
alpha
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 SINGLE-FACTOR MODEL
AND OPTIMAL PORTFOLIO
We can use alpha and beta estimates as well as risk
and return estimates for the market index
stemming from macroeconomic analysis to
generate the efficient frontier in a similar fashion
to that employed under the Markowitz Portfolio
Selection Model
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 SINGLE-FACTOR MODEL AND OPTIMAL PORTFOLIO
Recall we can construct the covariance matrix
with Beta, residual variance and index variance
estimates.
2 2 2 2
𝜎 = 𝛽 𝜎𝑚 + 𝜎 (𝑒𝑖 )
𝑖 𝑖

2
𝑐𝑜𝑣(𝑟 𝑖 , 𝑟 𝑗 ) = 𝛽𝑖 𝛽𝑗 𝜎𝑚

we can then identify the optimal risky portfolio

by maximising the Sharpe ratio whilst ensuring
weights held in all risky assets sum to 1
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SINGLE-FACTOR MODEL AND
OPTIMAL PORTFOLIO
Single-index model input list:
Risk premium on the index portfolio
Standard deviation of the index portfolio
n sets of estimates of:
Beta coefficients
Stock residual variances
Alpha values
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 SINGLE-FACTOR MODEL AND
OPTIMAL PORTFOLIO
However, when returns follow the index model, we can
use an approach proposed by Treynor and Black (1971) to
directly solve for the optimal risky portfolio. To do this, we
must view the portfolio as a combination of
An active portfolio, A, comprising the n analysed
securities with significant alphas in some weight
The market-index portfolio, M, which is a passive
portfolio.
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 SINGLE-FACTOR MODEL AND
OPTIMAL PORTFOLIO
The weight in which the active portfolio will be held
in the optimal risky portfolio will:
Reflect both its contribution to the optimal risky
portfolio (ie via its alpha); and,
Also take into account how it contributes to the
risk of the optimal risky portfolio (ie via its
residual variance.
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 INDEX MODEL AND
DIVERSIFICATION
Variance of the equally-weighted portfolio of firm-
specific components:

When n gets large, 𝜎 (𝑒 ) becomes negligible

2
𝑝

As diversification increases, the total variance of

a portfolio approaches the systematic variance 21
INDEX MODEL AND
DIVERSIFICATION

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INDEX MODEL SHARPE
RATIO

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TRADE OFF IN INDEX MODEL OPTIMAL
PORTFOLIO
Positive alpha securities provide returns above
what they should given their market risk (ie they
are underpriced), so should be overweighted
relative to the market portfolio; The reverse is
true for negative alpha securities.
However, by deviating from the market portfolio,
we introduce unsystematic risk
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TRADE OFF IN INDEX MODEL OPTIMAL
PORTFOLIO
trade off between search for alpha and
sacrificing efficient diversification
𝛼𝐴

𝜎(𝑒𝐴 )

portfolio A is the active portfolio

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 SINGLE-FACTOR MODEL AND
OPTIMAL PORTFOLIO
The Sharpe ratio of an optimally constructed risky
portfolio will be greater than that enjoyed by the
index (passive portfolio):
𝛼𝐴 2
2 2
𝑠𝑝 = 𝑠 + [ ]
𝑀
𝜎(𝑒𝐴 )

The extra return provided by security analysis will

be captured by the information ratio.
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 SINGLE-FACTOR MODEL AND
OPTIMAL PORTFOLIO: AN EXAMPLE

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SINGLE-FACTOR MODEL AND
OPTIMAL PORTFOLIO

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 SINGLE-FACTOR MODEL AND
OPTIMAL PORTFOLIO
Full Markowitz model is better in principle, but
The full-covariance matrix invokes estimation
risk of lots of terms
Cumulative errors may result in a portfolio that
is actually inferior
The single-index model is practical and
decentralizes macro and security analysis
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 THE INDEX MODEL IN
PRACTICE
The index model has become a benchmark used by
practitioners. However, practitioners often estimate the
model using total rather than excess returns

𝑅𝑖𝑡 = 𝑟 𝑓 + 𝛼 𝑖 + 𝛽𝑖 (𝑟 𝑀 𝑡 − 𝑟 𝑓 ) + 𝑒𝑖𝑡

𝑅𝑖𝑡 = 𝛼 𝑖 + 𝑟 𝑓 (1 − 𝛽𝑖 ) + 𝛽𝑖 𝑟 𝑀 𝑡 + 𝑒𝑖𝑡

The slope coefficient should remain unchanged if 𝑟 does 𝑓

not vary over time 30

 THE INDEX MODEL IN
PRACTICE
Betas tend towards one over time;
This trend suggests betas estimated using
historical data may not provide the best estimate
of future betas; and,
Therefore, it may be necessary to forecast betas
in some manner.
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THE INDEX MODEL IN
PRACTICE
Ajusted beta model
2 2
̂
𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑𝑏𝑒𝑡𝑎 = 𝛽 + 1
3 3

Forecast beta
̂
𝑐𝑢𝑟𝑟𝑒𝑛𝑡𝑏𝑒𝑡𝑎 = 𝑎 + 𝑏𝛽 + 𝑐 × 𝑓 𝑖𝑟𝑚𝑐ℎ𝑎𝑟𝑎𝑐

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 THE INDEX MODEL IN
PRACTICE
Empirical evidence suggests that the following
variables are useful in predicting betas:
Variance of earnings and cash flows;
Growth in EPS;
Firm size;
Dividend yield;
Firm leverage, as measured by the ratio of debt
to assets; and
Industry in which the firm operates. 33