CHAPTER 8

Index Models

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Advantages of the Single Index

Model over the Markowitz
• 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:
Cov(ri , rj )  i  j M2

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Single-Index Model
• Correlation = product of correlations with
the market index

i  j M2 i M2  j M2
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:
2
n
1 2 1 2
 (eP )      (ei )   (e)
2

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 8.2 Excess Returns on HP and

S&P 500

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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 & P 500 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.
• Regression Sum of Square (SS): .3752 is the proportion of
the variance explained by market return.
• Mean SS of Residual 0.0059 show the variance of the
unexplained (e). Square root is the std error of the residual
0.0767.
• Total SS is the total variance of HP (.7162)  monthly
variance: .7162/59=.012 per month or monthly
std=.012^.5=11% (and annualize std=38.17%)
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Table 8.1 Interpretation

• HP’s alpha is 0.86% per month(10.32% annually) but it is
not statistically significant.
• HP’s beta is 2.0348, statistically significant.
• Firm specific risk: Residual Standard Error: .0767
• Standard error of systematic risk:
• Beta*std(SP500) = 2.03*13.58%=27.57%

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Figure 8.4 Excess Returns on Portfolio

Assets

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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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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   n 1

2 n 1  2
 P    P M   (eP )    M   wi i    wi  (ei ) 
2 2 2 2 2 2 2

  i 1  i 1 
E ( RP )
SP 
P

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Optimal Risky Portfolio of the

Single-Index Model
Modification of active portfolio position:
0
* w
wA  A
1  (1   A ) w0A

When
* 0
 A  1, w  w
A A

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Figure 8.5 Efficient Frontiers with the

Index Model and Full-Covariance Matrix

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Is the Index Model Inferior to the

Full-Covariance Model?
• Full Markowitz model may be better in principle,
but
– Using the full-covariance matrix invokes
estimation risk of thousands of terms.
– Cumulative errors may result in a portfolio that
is actually inferior to that derived from the
single-index model.
– The single-index model is practical and
decentralizes macro and security analysis.

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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
Adjust beta 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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