V-601-EIGN

Portfolio Theory
Index Model, the Market Model
The Capital Asset Pricing Model
February 28th 2023
A single index model
Simplifies estimation of the covariance matrix and enhances the analysis of security risk
premiums.
Explicitly decompose risk into
• Systematic and
• Firm specific

Sheds light on the power and limits of diversification.

Properties are analyzed and the model is estimated from widely available data.
Statistical properties of the estimations relate to practical issues facing portfolio managers.
Despite the simplification they offer, index models remain true to the concepts of the
efficient frontier and portfolio optimization.
Reducing the inputs for diversification
The success of a portfolio selection rule depends on the quality of the input list.
In the long run, efficient portfolios will beat portfolios with less reliable input lists and
consequently inferior reward-to-risk trade-offs.
With increasing number of securities in a portfolio the task of thoroughly analysing each
stock and estimating expected returns, variances and covariances becomes a huge task
with a very high number of inputs and room for errors.
Smaller, necessarily consistent, and, just as important, more easily interpreted set of
estimates of risk parameters and risk premiums.
The simplification emerges because positive covariances among security returns arise
from common economic forces that affect the fortunes of most firms.
By decomposing uncertainty into systemwide versus firm-specific sources, we vastly
simplify the problem of estimating covariance and correlation.
Systematic versus Firm-Specific Risk
We focus on risk by separating the actual rate of return on any security, i, into the sum
of its previously expected value plus an unanticipated surprise:

The sources of return uncertainty can be uncertainty about the economy as a whole,
which is captured by a systematic market factor m, and uncertainty about the firm in
particular, which is captured by a firm-specific random variable ei.

The common dependence that virtually all firms have to macroeconomic conditions is
the source of the correlation between their security returns.
The unanticipated surprise
m, the market factor, measures unanticipated developments in the macroeconomy.
• e.g. the difference between GDP growth and the market’s previous expectation of growth.
• has a mean of zero (over time, surprises will average out to zero) and st.deviation σm.

ei measures only the firm-specific surprise.

• also has zero expected value.
m and ei assumed to be uncorrelated
• ei being firm-specific is independent of shocks to the common factor that affect the entire
economy.
The variance of ri thus arises from two uncorrelated sources, systematic and firm-specific.
Some securities will be more sensitive than others to macroeconomic shocks
• Each firm assigned a sensitivity coefficient to macro conditions,
A Single-Factor Market
• Advantages
• Reduces the number of inputs for diversification
• Easier for security analysts to specialize
• Model

• = response of an individual security’s return to the common factor, m

• m = a common macroeconomic factor (systematic risk)
• = firm-specific surprises
Single-Index Model
• The systematic factor affects the rate of return on all stocks
• The single index model uses the market index to stand in for the common factor

• Regression equation:

• Expected return-beta relationship:

• Variance = Systematic risk + Firm-specific risk:

Single-Index Model
• The assumption is that firm-specific surprises are mutually uncorrelated
• only source of covariance between securities is common dependence on market return.
• the covariance depends on their betas representing sensitivity to the market.

• Covariance = Product of betas × Market index risk:

• Correlation = Product of correlations with the market index

Index Model and Diversification
• Variance of the equally-weighted portfolio of firm-specific components:

• When n gets large, σ2(ep)  0 negligible

• Firm specific risk is diversified away

The Variance of an Equally Weighted Portfolio
with Risk Coefficient βP

• No matter how many stocks are held,

their common exposure to the market
will result in a positive portfolio beta and
be reflected in portfolio systematic risk.
• Because firm specific risks are
independent, and all have zero
expected value, the law of averages
can be applied to conclude that as more
and more stocks are added to the
portfolio, the firm-specific components
tend to cancel out.
Excess Returns on Amazon and S&P 500

• Amazon’s returns generally follow those

of the index, but with noticeably larger
swings
• Monthly standard deviation of the excess
return on the index portfolio over the
period was 2.81%, while that of Amazon
was 8.06%.
• The larger swings in Amazon’s excess
returns suggest that we should find a
greater-than-average sensitivity to the
market index, that is, a beta greater than
1.0.
 Scatter Diagram – Amazon against the market index
and Amazon’s security characteristic line (SCL)

• The slope of the line reflects the sensitivity of

Amazon’s return to market conditions, the beta
coefficient (i). A steeper line implies that the rate of
return is more responsive to the market return.
• Firm-specific events also have a significant impact
as the scatter of points around the line show.
• The intercept is the expected excess return when
the market excess return is zero (α).

• ei is the zero-mean, firm-specific surprise in the

return in month t, also called the residual.
• The greater the residuals (positive or negative), the
wider is the scatter of returns around the line.
Index Model Regression Equation
Excess return of security i

𝑅𝑖 ( 𝑡 )=𝛼 𝑖 + 𝛽𝑖 𝑅 𝑆∧ 𝑃 500 ( 𝑡 ) +𝑒 𝑖 (𝑡 )

Expected excess
return when the Zero-mean, firm-
market excess Sensitivity of specific surprise
Expected excess in security i‘s
return is zero security i‘s return
return of the return in month t.
to changes in the
market (the residual)
return of the
market
Regression Results for the SCL of Amazon
• Correlation of Amazon with the S&P 500
is 0.5351, which is fairly high.
• The model explains about 27% of the
variation in Amazon’s returns.
• Amazon’s alpha is 1,92% per month and
barely statistically significant with very
low standard error and p-value below 5%.
• Amazon’s beta is 1.5326 with a 95%
confidence interval between 0.9026 and
2.1626
Portfolio Construction and the Single-Index
Model
• Alpha and Security Analysis
1. Macroeconomic analysis estimates the risk premium and market risk
2. Statistical analysis estimates the beta coefficients and residual variances,
σ2(ei), of all securities
3. Establish the expected return of each security absent any contribution from
security analysis
4. Use security analysis to develop private forecasts of the expected returns for
each security
Portfolio Construction and the Single-Index
Model
• Single-Index Model Input List
1. Risk premium on the S&P 500 portfolio
2. Estimate of the standard deviation of the S&P 500 portfolio
3. n sets of estimates of
- Beta coefficient
- Stock residual variances
- Alpha values
Portfolio Construction and the Single-Index
Model
• Optimal risky portfolio in the single-index model
• Expected return, standard deviation and Sharpe ratio:
Portfolio: The Process
• Optimal risky portfolio in the single-index model is a combination of
• Active portfolio, denoted by A
• Passive portfolio, denoted by M
The Market Model
• The market model is a market weighted
portfolio of all stocks in a stock exchange
or country or sector.
• It is a smart way to invest although only
countries/stock exchanges/sectors with
good relative strength should be
considered.
• It offers a diversified collection of
stocks with low cost and solid returns.
• It is possible to invest in market portfolios
Markowitz is among the greatest thinkers
that mirror stock indexes either with an of asset management in the 20th century.
index funds or ETFs, both of which are
managed through a computer algorithm.
Capital Asset Pricing Model (CAPM)
• It is the equilibrium model that underlies all modern financial theory
• Derived using principles of diversification with simplified assumptions
• Based on two sets of assumptions about investors behavior and market
structure
• Markowitz, Sharpe, Lintner and Mossin are researchers credited with its
development
Assumptions
Resulting Equilibrium Conditions
• All investors will hold the same portfolio for risky assets, the market portfolio.

• Market portfolio contains all securities and the proportion of each security is its
market value as a percentage of total market value.
The Efficient Frontier and the Capital Allocation
Line
The Efficient Frontier and the Capital Market
Line
Market Risk Premium
• The risk premium on the market portfolio must be just high enough to induce
investors to hold the available supply of stocks.
• The risk premium on the market portfolio is proportional to its risk and the
degree of risk aversion:

• = the average degree of risk aversion across investors

• = the variance of the market portfolio
Return and Risk for Individual Securities
• An individual security’s risk premium is a function of:
• Its contribution to the risk of the market portfolio
• The covariance of returns with the assets that make up the market portfolio
Individual Securities: Example
• Covariance of GE return with the market portfolio:

• The reward-to-risk ratio for GE would be:

GE Example
• The market portfolio is the tangency (efficient mean-variance) portfolio.
• Reward-to-risk ratio for investment in market portfolio (market price of risk):

• Investments should offer the same reward-to-risk ratio so these ratios should equal:

• The risk premium for GE:

βGE

• Restating, we obtain:
CAPM
• The CAPM predicts that systematic risk should “be priced,” meaning that it
commands a risk premium, but firm-specific risk should not be priced by the market.
• The expected return–beta relationship holds for each individual asset, so it must hold
for any combination or weighted average of assets.
• The logic of the CAPM is that the only reason for a stock to provide a premium over
the risk-free rate is that the stock imposes systematic risk for which the investor must
be compensated.
The Security Market Line
• The expected return–beta relationship is a
reward–risk equation and can be shown
graphically as the security market line
(SML).
• The market’s beta is 1
• The slope is the risk premium of the
market portfolio.
• On the horizontal axis where β = 1 it
shows the expected return for the
market portfolio on the vertical axis.
• All securities must lie on the SML in
market equilibrium.
The SML and a Positive-Alpha Stock
• The difference between the fair and
actually expected rate of return on a
stock is the alpha,
• For example:
• If the market return is expected to be 14%, a
stock has a beta of 1.2, and the T-bill rate is
6%, the SML would predict an expected
return on the stock of
6 + 1.2(14 − 6) = 15.6%
• If one believed the stock would provide an
expected return of 17%, the implied alpha
would be 1.4%
Next week
Efficient Market Hypothesis