Jiayu LUO z3219847

THE SINGLE INDEX MODEL DUE IN WEEK 8

Session 9 A. The single index model SIM! equation is defined as: ( rit rf ) = i + i ( rmt rf ) + it where: rit is the return on the stock i observed in eriod t !instead of redicted at the be"innin" of eriod# rmt is the return on a $arket inde% observed in eriod t rf is the return on the risk&free asset in the sa$e eriod

i and i are the stock's a( ha and beta it is the "esid#$l "e%#"n of stock i in eriod t
The &'$"$&%e"is%i& line is defined as: = + ( r r R it i i mt f where:

is the return on the stock i redicted at the be"innin" of R it eriod t !instead of observed in the eriod# rmt is the return on a $arket inde% redicted in the eriod t rf is the return on the risk&free asset in the sa$e eriod

i and i are the stock's a( ha and beta

)hi(e the *+, equation is used for esti$atin" a( ha and beta- as we(( as for e% (ainin" the source of the residua( return observed in a eriod- the characteristic (ine is used to re ort the (inear re(ationshi between stock e%cess return and the $arket inde% e%cess return and for co$ utin" the e%cess return redicted- rather than observed- by the $ode(. (. /01 )oe**i&ien%s o* SIM 1( ha t&stat of a( ha 0eta t&stat of beta O%'e" S%$%is%i&s 62
2 6esidua( variance- i 2 8%cess return variance- i

210 4.4412 !4.52# 1.21 !5.48# 4.57 4.44448 7 4.44423 9 &

1(( 3rds & & & & & & 4.444145 4.27:

&4.4414 &!4.53# 4.54 !4.14# 4.42 4.44447 2 4.44449 4 &

9istorica( avera"e e%cess return on 1(( 3rds ).

(r

CBA

rf ) = 0.0010 + 0.60 ( rAll Ords rf

Jiayu LUO z3219847 D. ;ir$ s ecific risk refers to the risk that is the resu(t of a deviation of the actua( observed return fro$ the e% ected return of an invest$ent of a articu(ar fir$ as a direct resu(t fro$ fir$&s ecific !not $arket re(ated# news such as a better than e% ected earnin"s announce$ent. <iven its (ar"e residua( variance !(ar"er than both 210 and /01#- 09= has the (ar"est fir$&s ecific risk. The variance of residua( return is a ro riate because the residua( return ca tures the difference between the actua( return and that redicted by the sin"(e inde% $ode(. E. ,arket risk refers to the risk as a resu(t of a deviation of actua( return fro$ that e% ected as a direct resu(t of the arriva( of une% ected !or unforeseen# $acro&econo$ic news such as a hi"her than e% ected inf(ation fi"ure. 09= has the (ar"est beta- and hence- the (ar"est $arket risk. 0eta is a $easure of the re(ative sensitivity of stock returns to $arket $ove$ents- and therefore it is the a ro riate $easure. +. <iven its (ar"e 62- 210 has its return variabi(ity e% (ained the $ost by the $arket inde%. 62 is an a ro riate $easure because it ref(ects the ro ortion of variation in the de endent variab(e !e%cess return of stock# bein" e% (ained by the variation in the inde endent variab(e !e%cess return of the $arket inde%#. G. 210 had an avera"e return in e%cess of that redicted by the /1=,- "iven by its ositive a( ha. 9owever- since the t&statistic of a( ha is (ess than twoa( ha is insi"nificant(y different fro$ zero- which i$ (ies that the stock is correct(y riced under /1=,. The variance of /01 !4.4449# can be broken down into: 1# syste$atic risk > > > > >

H.

2# fir$&s ecific risk ,.

2 variance of returns on market index 0.62 0.000106 0.000038 residual variance 0.000052

The in ut require$ents are 1# the stock a( ha- 2# the stock beta and 3# a forecast on the e%cess $arket inde% return over the forthco$in" eriod. The stock a( ha and beta are esti$ated by runnin" an 3?* re"ression on the sin"(e inde% $ode( usin" a set of historica( data. The three in uts are then a (ied to the characteristic (ine to obtain the e% ected return as fo((ows: E [ Ri ] = ( ri rf ) = i + i ( rm rf )