Chapter Eight

Index Models

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Chapter Overview
• Drawbacks to Markowitz procedure
• Requires a huge number of estimates to fill the
covariance matrix
• Model does not provide any guidelines for finding useful
estimates of these covariances or the risk premiums
• Introduction of index models
• Simplifies estimation of the covariance matrix
• Enhances analysis of security risk premiums
• Optimal risky portfolios constructed using the index
model
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education 8-2
 A Single-Factor Security Market
• Advantages of the single-index model
• Number of estimates required is a small fraction of what
would otherwise be needed
• Specialization of effort in security analysis
ri  E ri    i m  ei

• βi = sensitivity coefficient for firm I

• m = market factor that measures unanticipated
developments in the macroeconomy
• ei = firm-specific random variable
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education 8-3
 Single-Index Model
(1 of 2)

• Regression equation (monthly)

Ri t    i   i RM t   ei t 

• Expected return-beta relationship

E Ri    i   i E RM 

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-4
 Single-Index Model
(2 of 2)

• Total risk = Systematic risk + Firm-specific risk

 i2   i2 M2   2 ei 

• Covariance = Product of betas × Market-index risk

Cov  ri , rj   i  j 2
M

• Correlation = Product of correlations with the

market index

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-5
 Index Model and Diversification
• Variance of the equally-weighted portfolio of
firm-specific components:

• When n gets large, σ2(ep) becomes negligible

• As diversification increases, the total variance
of a portfolio approaches the systematic
variance
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education 8-6
The Variance of an Equally Weighted
Portfolio with Risk Coefficient, βp

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-7
Excess Monthly Returns on Amazon
and the Market Index

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-8
Scatter Diagram

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-9
Security Characteristic Line (SCL)
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

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-10
Excel Output: Regression Statistics

Concept Check 8.1 p(249)

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-11
 The Industry Version of the Index
Model
• Predicting betas
• Betas tend to drift to 1 over time

• Rosenberg and Guy found the following variables to

help predict betas:
1. Variance of earnings
2. Variance of cash flow
3. Growth in earnings per share
4. Market capitalization (firm size)
5. Dividend yield
6. Debt-to-asset ratio
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education
Industry Version of the Index Model

Alpha is a nonmarket risk premium

𝐸 ( 𝑅 𝑖 ) =𝑟𝑓 + 𝛽 𝑖 ¿ 𝐸 ( 𝑅 𝑀 ) −𝑟𝑓 }¿

INVESTMENTS | BODIE, KANE, MARCUS

 Portfolio Construction and
the Single-Index Model (1 of 3)
• Alpha and security analysis
1. Macroeconomic analysis used to estimate the risk
premium and risk of the market index
2. Statistical analysis used to estimate beta coefficients
and residual variances, σ2(ei), of all securities
3. Establish expected return of each security absent
any contribution from security analysis
4. Security-specific expected return forecasts are
derived from various security-valuation models

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-14
 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. Standard deviation of the S&P 500 portfolio
3. n sets of estimates of:
• Beta coefficients
• Stock residual variances
• Alpha values

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-15
 Portfolio Construction and
the Single-Index Model (3 of 3)
• Optimal risky portfolio in the single-index model
• Objective is to select portfolio weights to maximize
the Sharpe ratio of the portfolio

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-16
 Portfolio Construction: The Process
• Optimal risky portfolio in the single-index
model is a combination of two component
portfolios:
• Active portfolio, denoted by A
• Market-index portfolio (i.e., passive portfolio),
denoted by M

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-17
Summary of Optimization Procedure
(1 of 4)

1. Compute the initial position of each security:

i
w 
0
i
 2 (ei )

2. Scale those initial positions:

0
wi
wi  n

 i
w 0

i 1

3. Compute the alpha ofn the active portfolio:

 A   wi i
i 1

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-18
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

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-19
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

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-20
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:

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-21
 Optimal Risky Portfolio:
Information Ratio
• Information Ratio
• The contribution of the active portfolio depends
on the ratio of its alpha to its residual standard
deviation (Step 5)
• Calculated as the ratio of alpha to the standard
deviation of diversifiable risk
• The information ratio measures the extra return
we can obtain from security analysis

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education
 Optimal Risky Portfolio:
Sharpe Ratio
• The Sharpe ratio of an optimally constructed
risky portfolio will exceed that of the index
portfolio (the passive strategy):
2
2 2  A 
s P  s M    (eA ) 

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-23
 Efficient Frontier:
Index Model and Full-Covariance Matrix

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-24
Portfolios from the Index and Full-
Covariance Models

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-25
 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

INVESTMENTS | BODIE, KANE, MARCUS

©2021 McGraw-Hill Education 8-26