CHAPTER 8 Index Models

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Advantages of the Single Index Model

• Reduces the number of inputs for

diversification
• Easier for security analysts to specialize

8-2
 Single Factor Model

ri  E (ri )  i m  ei
ßi = index of a securities’ particular return to the
factor
m = Assumption: a broad market index like the
S&P 500 is the common factor.
ei = Unanticipated movement related to security
returns

8-3
 Single-Index Model

• Regression Equation:
Rt (t )   i   t RM (t )  ei (t )

• Expected return-beta relationship:

E ( Ri )   i  i E ( RM )

8-4
 Single-Index Model Continued

• Risk and covariance:

– Total risk = Systematic risk + Firm-specific
risk:  i2   i2 M2   2 (ei )
– Covariance = product of betas x market index
risk:
Cov(ri , rj )  i  j M2

– Correlation = product of correlations with the

market index
i  j M2 i M2  j M2
Corr (ri , rj )    Corr (ri , rM ) xCorr (r j , rM )
 i j  i M  j M

8-5
 Index Model and Diversification
• Portfolio’s variance:

      (eP )
2
P
2
P
2
M
2

• Variance of the equally weighted portfolio of

firm-specific components:
2
n
1 2 1 2
 (eP )      (ei )   (e)
2

i 1  n  n
• When n gets large, becomes negligible
 (eP )
2

8-6
Figure 8.1 The Variance of an Equally
Weighted Portfolio with Risk Coefficient
βp in the Single-Factor Economy

8-7
Figure 8.2 Excess Returns on HP and
S&P 500 April 2001 – March 2006

8-8
 Figure 8.3 Scatter Diagram of HP, the
S&P 500, and the Security Characteristic
Line (SCL) for HP

8-9
 Table 8.1 Excel Output: Regression
Statistics for the SCL of Hewlett-Packard

8-10
Figure 8.4 Excess Returns on Portfolio
Assets

8-11
 Alpha and Security Analysis

• Macroeconomic analysis is used to estimate

the risk premium and risk of the market index
• Statistical analysis is used to estimate the
beta coefficients of all securities and their
residual variances, σ2 ( e i )
• Developed from security analysis

8-12
Alpha and Security Analysis Continued
• The market-driven expected return is
conditional on information common to all
securities
• Security-specific expected return forecasts are
derived from various security-valuation models
– The alpha value distills the incremental risk
premium attributable to private information
• Helps determine whether security is a good or
bad buy

8-13
 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

8-14
Optimal Risky Portfolio of the Single-
Index Model
• Maximize the Sharpe ratio
– Expected return, SD, and Sharpe ratio:
n 1 n 1
E ( RP )   P  E ( RM )  P   wi i  E ( RM ) wi  i
i 1 i 1
1
1  2 
n 1 2
 n 1 2 2  2
 P    P M   (eP )    M   wi  i    wi  (ei ) 
2 2 2 2

  i 1  i 1 
E ( RP )
SP 
P

8-15
Optimal Risky Portfolio of the Single-
Index Model Continued
• Combination of:
– Active portfolio denoted by A
– Market-index portfolio, the (n+1)th asset
which we call the passive portfolio and
denote by M
– Modification of active portfolio position:
0
w
wA 
* A
1  (1   A ) wA
0

– When  A  1, w  w
*
A
0
A
8-16
 The Information Ratio

• The Sharpe ratio of an optimally constructed

risky portfolio will exceed that of the index
portfolio (the passive strategy):
2
2  A 
2
s P s M   (eA ) 
 

8-17
 Figure 8.5 Efficient Frontiers with the
Index Model and Full-Covariance Matrix

8-18
Table 8.2 Comparison of Portfolios from
the Single-Index and Full-Covariance
Models

8-19
Table 8.3 Merrill Lynch, Pierce, Fenner &
Smith, Inc.: Market Sensitivity Statistics

8-20
Table 8.4 Industry Betas and Adjustment
Factors

8-21