Chapter Eight

Index Models

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 Chapter Overview
• Advantages of a single-factor model
• Risk decomposition
• Systematic vs. firm-specific
• Single-index model and its estimation
• Optimal risky portfolio in the index model
• Index model vs. Markowitz procedure

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 A Single-Factor Market
• Advantages
• Reduces the number of inputs for diversification
• Easier for security analysts to specialize
• Model
ri  E ri    i m  ei
• βi = response of an individual security’s return to the
common factor, m
• m = a common macroeconomic factor (systematic risk)

• ei =firm-specific surprises
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 Single-Index Model
(1 of 3)

• 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
(2 of 3)

• Variance = Systematic risk + Firm-specific risk:

      ei 
i
2
i
2 2
M
2

• Covariance = Product of betas × Market risk:

Cov  ri , rj   i  j 2
M

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 Single-Index Model
(3 of 3)

• Correlation =

i  j M2  i M2  j M2
Corr  ri , rj   
 i j  i M  j M
 Corr  ri , rM   Corr  rj , rM 

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 Index Model and Diversification
• Variance of the equally-weighted portfolio of
firm-specific components:
2

 e p       ei    e 
2
n
1 2 1 2
i 1  n  n

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

• Firm specific risk is diversified away

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The Variance of an Equally Weighted
Portfolio with Risk Coefficient βp

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Excess Returns on Ford and S&P 500

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Scatter Diagram of Ford, the S&P 500,
and Ford’s SCL

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Index Model Regression Equation
Excess return of security i

Ri t    i   i RS & P 500 t   ei t 
Zero-mean, firm-
Expected excess
specific surprise
return when the
in security i‘s
market excess
return in month t.
return is zero
(the residual)
Sensitivity of
security i‘s return Expected excess
to changes in the return of the
return of the market
market

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Excel Output: Regression Statistics
for the SCL of Ford

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 Interpreting the Output
• Correlation of Ford with the S&P 500 is 0.6280
• The model explains about 38% of the variation
in Ford
• Ford's alpha is -0.98% per month, but not
statistically significant
• Ford's beta is 1.3258, but the 95% confidence
interval is 0.90 to 1.75

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 Portfolio Construction and
the Single-Index Model (1 of 3)
• 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

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 Portfolio Construction and
the Single-Index Model (2 of 3)
• Single-Index Model Input List
1. Risk premium on the S&P 500 portfolio
2. Estimate of the SD of the S&P 500 portfolio
3. n sets of estimates of
• Beta coefficient
• Stock residual variances
• Alpha values

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 Portfolio Construction and
the Single-Index Model (3 of 3)
• Optimal risky portfolio in the single-index
model
• Expected return, SD, and Sharpe ratio:

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 Portfolio Construction: The Process
• Optimal risky portfolio in the single-index
model is a combination of
• Active portfolio, denoted by A
• Passive portfolio, denoted by M

See Spreadsheet 8.1 for a detailed example of the following procedure

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Summary of Optimization Procedure
(1 of 4)

1. Compute the initial position of each security:

i
w 
0
i
 2 (ei )

2. Scale those positions:

wi0
wi  n

 i
w 0

i 1

3. Compute the alpha ofn the active portfolio:

 A   wi i
i 1

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Summary of Optimization Procedure
(2 of 4)

4. Compute the residual variance of A:

n
 2 (eA )   wi2 2 (ei )
i 1

5. Compute the initial position in A:

  2
(e A )
wA 
0 A

E ( RM )  M2

6. Compute the beta ofn A:

 A   wi i
i 1

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Summary of Optimization Procedure
(3 of 4)

7. Adjust the initial position in A:

0
w
wA 
* A
1  (1   A )  wA
0

Note when  A  1
w w *
A
0
A

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Summary of Optimization Procedure
(4 of 4)

8. Optimal Risky Portfolio


now has weights:
wM  1  wA
wi  wA  wi

9. Calculate the risk premium of P (Optimal Risky

Portfolio):
E ( RP )  ( wM  wA  A )  E ( RM )  wA A

10. Compute the variance of P:

 2 (eA )  ( wM  wA  A ) 2  M2  [ wA (eA )]2

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 Optimal Risky Portfolio:
Information Ratio
• The Information Ratio
• The contribution of the active portfolio depends
on the ratio of its alpha to its residual standard
deviation (Step 5):
Information Ratio of A
  2
(e A )
wA 
0 A
E ( RM )  M2
• The information ratio measures the extra return
we can obtain from security analysis

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 Optimal Risky Portfolio:
Sharpe Ratio
• The Sharpe ratio of an optimally constructed
risky portfolio will exceed that of the index
portfolio:
2
2 2  A 
s P  s M    (eA ) 

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Efficient Frontiers of Index Model vs.
Full-Covariance Matrix

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Portfolios from the Single-Index and
Full-Covariance Models

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

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