CHAPTER 8: INDEX MODELS

CHAPTER OVERVIEW
The single-factor index model is introduced; this model predicts stock returns based upon both
the firm specific and market risks of the security. Using the single-factor model allows the risk to
be decomposed into systematic and unsystematic components and reduces the number of inputs
required to diversify in an efficient manner. The chapter addresses practical issues that arise
when implementing the index model.

LEARNING OBJECTIVES
Upon completion of this chapter, the student should have a full understanding of systematic and
firm-specific risk and of how one can reduce the amount of firm-specific risk in the portfolio by
combining securities with differing patterns of returns. Furthermore, if the portfolio is adequately
diversified and firm-specific (or nonsystematic), risk is virtually eliminated, then beta (or
systematic risk) becomes the relevant risk measure for the portfolio. The student should be able
to identify inputs required to use the index model and understand the characteristic line.

PRESENTATION OF MATERIAL
8.1 A Single-Factor Security Market (PowerPoint Slide 3)
The advantages of the single-factor or single-index model over the Markowitz model are
presented here. One of the advantages of the single-factor model is the reduction in data that is
needed for portfolio analysis. With just 50 securities, the traditional diversification approach
requires over 1,300 estimates.

8.2 The Single-Index Model (PowerPoint Slides 4–11)

The single-factor model is developed in this first section. Basic properties associated with
diversification and the single-index model are presented. As n gets large, the error term becomes
negligible, and the risk remaining the portfolio is systematic.

Estimating the single-index model is demonstrated in detail using Amazon. A scatter diagram
form Amazon against the market index and Amazon’s security characteristic line is displayed in
Figure 8.1. Equation 8.5 illustrates the regression equation, and Equation 8.6 demonstrates the
relationship between expected return and alpha (here defined as excess return when market
return is zero), beta (sensitivity to changes in market returns), and expected market returns.
Equation 8.7 summarizes the risks constructed and accounted for in a single-index model.

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This section concludes with a discussion on diversification and variance within the index model.
Figure 8.2 illustrates this. Equations 8.8–8.14 are generic equations that work through the
textbook illustration.

8.3 Estimating the Single-Index Model (PowerPoint Slides 12–14)

This section walks through the steps of estimating the parameters of the index model using U.S.
Steel and Equation 8.5. Table 8.1 displays the complete regression analysis, and a plot of the
excess returns and market index are overlaid in Figure 8.3. This section proceeds to estimate
alpha, beta, and firm-specific risk for a variety of companies in Table 8.2.

8.4 The Industry Version the Index Model (PowerPoint Slides 15–17)
Consideration of the differences between the industry version of the single-index model and the
single-index model developed in the text are covered in this final section. The industry version
that is presented does not use a risk premium format, so the estimate of alpha is not consistent
with the version developed in the text. Further betas are adjusted for tendency of beta to regress
toward a mean of 1.0 over time. Example 8.1 works through an adjusted beta example following
the Amazon example. Table 8.3 displays industry betas and their corresponding adjustment
factors.

8.5 Portfolio Construction Using the Single-Index Model (PowerPoint Slides 18–30)
This section presents alpha and security analysis along with the single-index model input list.
The text develops the concept of the information ratio and describes how to optimally weight the
actively managed portfolio with the passive or index portfolio; this method is called the Treynor-
Black model. Equations 8.22–8.27 present the process. Spreadsheet 8.1 implements this process
and can be found at http://www.mhhe.com/Bodie13e.

Figure 8.4 illustrates the efficient frontier constructed from the index model and the full
covariance matrix. Table 8.4 compares weights and portfolio characteristics for the single-index
model and the full-covariance approach. It is suggested that instructors walk students through the
Summary of Optimization Procedure.

Excel Applications
Connect Integrated Excel models are available for a variety of learning outcomes in this chapter.
Please utilize the questions developed in Connect!

KEY TERMS
single-factor model single-index model scatter diagram

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regression equation security characteristic line Treynor-Black model
(SCL)
residuals Information ratio

KEY EQUATIONS

Singl-index model (in excess returns):

Security risk in index model:

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Total risk = Systematic risk + Firm-specific risk

Active portfolio management in the index model

Sharpe ratio of optimal risky portfolio:

Asset weight in active portfolio:

Squared information ratio of active portfolio:

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