Sharpe’s Single Index Model

Chapter Objectives

• Discussing the basic tenets of the single

index model
• Assessing systematic and unsystematic
risk of individual securities and portfolio
• Evaluating beta-excess return relationship
• Constructing optimal risky using single
index model
 Single Index Model

• Sharpe’s model is also called market model

as it assumes that the co-movement between
two stocks is due to their movement with the
index representing the market as a whole.
• Sharpe used a broad index of securities (like
S&P BSE SENSEX or S&P 500 or STI) as a
proxy for measuring the change in expected
return of a security due to macroeconomic
factors.
 Single Index Model

• The model implies that the rates of returns

of securities are correlated on account of
their individual relationship with some
basic underlying factors.
• The sensitivity of a stock to the movement
in the market index is measured by beta.
 Single Index Model

• Sharpe’s model is symbolically expressed as:

 Single Index Model
The single index model is based on certain
assumptions:
• The error term (ei) is a zero mean term
with finite variance. Its covariance with the
market portfolio is zero.
• The error term of one security has no
connection with the error term of another
security.
 Single Index Model
• The expected value of error term is zero.
 Risk Return Relationship in
Single Index Model

Beta – Expected Return Relationship

• The single index model divides the return
on a security into two components:
- a unique part, αi
- a market-related part, βi
 Risk Return Relationship in
Single Index Model

Variance, Covariance and Correlation as

Measures of Risk
• Variance: According to this model, for any
security,
Total risk = Systematic risk + Unique or
firm specific risk. Symbolically,
 Risk Return Relationship in
Single Index Model

• Covariance: Covariance between any pair of

securities is product of the respective betas and
the variance of the market.
Cov (ri, rj) = Product of betas × Variance of market
index
• The covariance between the return on stock i and
the market index is given as:
Risk Return Relationship in Single Index Model

• Correlation: Correlation between two

securities, i and j may be given as the
product of correlations of i and j with the
market.
 Security Characteristic Line

• Sharpe’s single index model is

represented by the equation:
 Security Characteristic Line

• SCL is a regression line that represents the

relationship between the returns on the stock and the
returns on the market over a period of time in the past
• The slope of the characteristic line is the Beta
Coefficient.
• If the coefficient of determination is equal to 1.00, it
would imply that all the points of observation would lie
on SCL. This would mean that the characteristic line
explains 100% of the variability of the dependent
variable (the stock returns).
 Security Characteristic Line
• The alpha is the vertical intercept of the
characteristic line.
• Many analysts and portfolio managers
search out stocks with high alphas.
Application of the single index model for diversification

• The single index model and its risk-return

computation can be used for
diversification, i.e., for construction of a
portfolio.
• For a portfolio, written may be computed
as:
Application of the single index model for
diversification
The return of the portfolio of ‘n’
securities where weight of each security is
equal to 1/n may be computed as:
 Application of the single index model
for diversification
• βp may be measured here as:
 Application of the single index model
for diversification
• The non-market component of the
portfolio, return αp can be measured as
Application of the single index model
for diversification
• Another non-market component ep is
measured as
Application of the single index model
for diversification
• The risk of the portfolio may be
computed as:
 Application of the single index model
for diversification
• The total risk of an equally weighted
portfolio of ‘n’ securities is given by:
 Application of the single index model
for diversification
• Assuming that the entire diversifiable risk
has been eliminated, the portfolio risk may
be measured as:
 Critique of Sharpe’s Single Index Model

The single index model scores over Markowitz’ MPT

in that it reduces the computational requirements
tremendously. However, Sharpe’s model suffers from
limitation of being over simplistic in its assumptions
about real-world uncertainty.