Chapter 08 - Index Models

CHAPTER8:INDEXMODELS
PROBLEMSETS
1.

Theadvantageoftheindexmodel,comparedtotheMarkowitzprocedure,isthevastly
reducednumberofestimatesrequired.Inaddition,thelargenumberofestimates
requiredfortheMarkowitzprocedurecanresultinlargeaggregateestimationerrors
whenimplementingtheprocedure.Thedisadvantageoftheindexmodelarisesfromthe
modelsassumptionthatreturnresidualsareuncorrelated.Thisassumptionwillbe
incorrectiftheindexusedomitsasignificantriskfactor.

2.

Thetradeoffentailedindepartingfrompureindexinginfavorofanactivelymanaged
portfolioisbetweentheprobability(orpossibility)ofsuperiorperformanceagainstthe
certaintyofadditionalmanagementfees.

3.

Theanswertothisquestioncanbeseenfromtheformulasforw 0andw*.Otherthings
heldequal,w 0issmallerthegreatertheresidualvarianceofacandidateassetfor
inclusionintheportfolio.Further,weseethatregardlessofbeta,whenw 0decreases,so
doesw*.Therefore,otherthingsequal,thegreatertheresidualvarianceofanasset,the
smalleritspositionintheoptimalriskyportfolio.Thatis,increasedfirmspecificrisk
reducestheextenttowhichanactiveinvestorwillbewillingtodepartfromanindexed
portfolio.

4.

Thetotalriskpremiumequals:+(marketriskpremium).Wecallalphaa
nonmarketreturnpremiumbecauseitistheportionofthereturnpremiumthatis
independentofmarketperformance.
TheSharperatioindicatesthatahigheralphamakesasecuritymoredesirable.Alpha,
thenumeratoroftheSharperatio,isafixednumberthatisnotaffectedbythestandard
deviationofreturns,thedenominatoroftheSharperatio.Hence,anincreaseinalpha
increasestheSharperatio.Sincetheportfolioalphaistheportfolioweightedaverageof
thesecuritiesalphas,then,holdingallotherparametersfixed,anincreaseinasecuritys
alpharesultsinanincreaseintheportfolioSharperatio.

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Chapter 08 - Index Models

5.

a.

Tooptimizethisportfolioonewouldneed:
n=60estimatesofmeans
n=60estimatesofvariances

n2 n
1,770 estimatesofcovariances
2
Therefore,intotal:
b.

n 2 3n
1,890 estimates
2

Inasingleindexmodel:rirf=i+i(rMrf)+ei
Equivalently,usingexcessreturns:Ri=i+iRM+ei
Thevarianceoftherateofreturnoneachstockcanbedecomposedintothe
components:
(l)

Thevarianceduetothecommonmarketfactor: i2 2M

(2)

Thevarianceduetofirmspecificunanticipatedevents: 2 (e i )

Inthismodel: Cov(ri , r j ) i j
Thenumberofparameterestimatesis:
n=60estimatesofthemeanE(ri)
n=60estimatesofthesensitivitycoefficienti
n=60estimatesofthefirmspecificvariance2(ei)
1estimateofthemarketmeanE(rM)
1estimateofthemarketvariance 2M
Therefore,intotal,182estimates.
Thus,thesingleindexmodelreducesthetotalnumberofrequiredparameter
estimatesfrom1,890to182.Ingeneral,thenumberofparameterestimatesis
reducedfrom:
n 2 3n

to (3n 2)
2

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Chapter 08 - Index Models

6.

a.

Thestandarddeviationofeachindividualstockisgivenby:
i [ i2 2M 2 (e i )]1 / 2

SinceA=0.8,B=1.2,(eA)=30%,(eB)=40%,andM=22%,weget:
A=(0.82222+302)1/2=34.78%
B=(1.22222+402)1/2=47.93%
b.

Theexpectedrateofreturnonaportfolioistheweightedaverageoftheexpected
returnsoftheindividualsecurities:
E(rP)=wAE(rA)+wBE(rB)+wfrf
wherewA,wB,andwfaretheportfolioweightsforStockA,StockB,andT
bills,respectively.
Substitutingintheformulaweget:
E(rP)=(0.3013)+(0.4518)+(0.258)=14%
Thebetaofaportfolioissimilarlyaweightedaverageofthebetasofthe
individualsecurities:
P=wAA+wBB+wff
ThebetaforTbills(f)iszero.Thebetafortheportfolioistherefore:
P=(0.300.8)+(0.451.2)+00.78
Thevarianceofthisportfoliois:
2P 2P 2M 2 (e P )

where 2P 2M isthesystematiccomponentand 2 (e P ) isthenonsystematic

component.Sincetheresiduals(ei)areuncorrelated,thenonsystematicvariance
is:
2 (e P ) w 2A 2 (e A ) w 2B 2 (e B ) w f2 2 (e f )

=(0.302302)+(0.452402)+(0.2520)=405
where2(eA)and2(eB)arethefirmspecific(nonsystematic)variancesofStocks
AandB,and2(ef),thenonsystematicvarianceofTbills,iszero.Theresidual
standarddeviationoftheportfolioisthus:
(eP)=(405)1/2=20.12%
Thetotalvarianceoftheportfolioisthen:
2P (0.78 2 22 2 ) 405 699.47

Thestandarddeviationis26.45%.

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Chapter 08 - Index Models

7.

a.

Thetwofiguresdepictthestockssecuritycharacteristiclines(SCL).StockAhas
higherfirmspecificriskbecausethedeviationsoftheobservationsfromtheSCL
arelargerforStockAthanforStockB.Deviationsaremeasuredbythevertical
distanceofeachobservationfromtheSCL.

b.

BetaistheslopeoftheSCL,whichisthemeasureofsystematicrisk.TheSCLfor
StockBissteeper;henceStockBssystematicriskisgreater.

c.

TheR2(orsquaredcorrelationcoefficient)oftheSCListheratiooftheexplained
varianceofthestocksreturntototalvariance,andthetotalvarianceisthesumof
theexplainedvarianceplustheunexplainedvariance(thestocksresidual
variance):

R2

i2 2M
i2 2M 2 (e i )

SincetheexplainedvarianceforStockBisgreaterthanforStockA(theexplained
varianceis 2B 2M ,whichisgreatersinceitsbetaishigher),anditsresidual
variance2(eB)issmaller,itsR2ishigherthanStockAs.

8.

d.

AlphaistheinterceptoftheSCLwiththeexpectedreturnaxis.StockAhasa
smallpositivealphawhereasStockBhasanegativealpha;hence,StockAsalpha
islarger.

e.

ThecorrelationcoefficientissimplythesquarerootofR2,soStockBscorrelation
withthemarketishigher.

a.

Firmspecificriskismeasuredbytheresidualstandarddeviation.Thus,stockA
hasmorefirmspecificrisk:10.3%>9.1%

b.

Marketriskismeasuredbybeta,theslopecoefficientoftheregression.Ahasa
largerbetacoefficient:1.2>0.8

c.

R2measuresthefractionoftotalvarianceofreturnexplainedbythemarketreturn.
AsR2islargerthanBs:0.576>0.436

d.

RewritingtheSCLequationintermsoftotalreturn(r)ratherthanexcessreturn
(R):
rArf=+(rMrf)rA=+rf(1+rM
Theinterceptisnowequalto:
+rf(11+rf(l1.2)
Sincerf=6%,theinterceptwouldbe:11.2=0.2%

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Chapter 08 - Index Models

9.

Thestandarddeviationofeachstockcanbederivedfromthefollowingequation
forR2:

i2 2M
R

i2
2
i

Therefore:
2A

2A 2M 0.7 2 20 2

980
0.20
R 2A

A 31.30%

ForstockB:
1.2 2 20 2
4,800
0.12
B 69.28%
2B

10.

ThesystematicriskforAis:
2A 2M 0.70 2 20 2 196

ThefirmspecificriskofA(theresidualvariance)isthedifferencebetweenAs
totalriskanditssystematicrisk:
980196784
ThesystematicriskforBis:
2B 2M 1.20 2 20 2 576

Bsfirmspecificrisk(residualvariance)is:
48005764224
11.

ThecovariancebetweenthereturnsofAandBis(sincetheresidualsareassumedtobe
uncorrelated):
Cov(rA , rB ) A B 2M 0.70 1.20 400 336

ThecorrelationcoefficientbetweenthereturnsofAandBis:
AB

Cov (rA , rB )
336

0.155
AB
31.30 69.28

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Chapter 08 - Index Models

12.

NotethatthecorrelationisthesquarerootofR2: R

Cov(rA,rM)=AM=0.201/231.3020=280
Cov(rB,rM)=BM=0.121/269.2820=480
13.

ForportfolioPwecancompute:
P=[(0.62980)+(0.424800)+(20.40.6336]1/2=[1282.08]1/2=35.81%
P=(0.60.7)+(0.41.2)0.90
2 (e P ) 2P 2P 2M 1282.08 (0.90 2 400) 958.08

Cov(rP,rM)=P 2M =0.90400=360
Thissameresultcanalsobeattainedusingthecovariancesoftheindividualstockswith
themarket:
Cov(rP,rM)=Cov(0.6rA+0.4rB,rM)=0.6Cov(rA,rM)+0.4Cov(rB,rM)
=(0.6280)+(0.4480)=360
14.

NotethatthevarianceofTbillsiszero,andthecovarianceofTbillswithanyassetis
zero.Therefore,forportfolioQ:

Q w 2P 2P w 2M 2M 2 w P w M Cov( rP , rM )

1/ 2

(0.5 2 1,282.08) (0.3 2 400) ( 2 0.5 0.3 360)

1/ 2

21.55%

Q w P P w M M (0.5 0.90) (0.3 1) 0 0.75

2 (e Q ) Q2 Q2 2M 464.52 (0.75 2 400) 239.52

Cov(rQ , rM ) Q 2M 0.75 400 300

15.

a.

MerrillLynchadjustsbetabytakingthesampleestimateofbetaandaveragingit
with1.0,usingtheweightsof2/3and1/3,asfollows:
adjustedbeta[(2/3)1.24]+[(1/3)1.0]=1.16

b. Ifyouuseyourcurrentestimateofbetatobet1=1.24,then
t=0.3+(0.7124)=1.168

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Chapter 08 - Index Models

16.

ForStockA:
A=rArf+A(rMrf)]=11[6+0.8(126)]=0.2%
ForstockB:
B=14[6+1.5(126)]=1%
StockAwouldbeagoodadditiontoawelldiversifiedportfolio.Ashortpositionin
StockBmaybedesirable.

17.

a.
Alpha()
i=ri[rf+i(rMrf)]

Expectedexcessreturn
E(ri)rf

A=20%[8%+1.3(16%8%)]=1.6%
B=18%[8%+1.8(16%8%)]=4.4%
C=17%[8%+0.7(16%8%)]=3.4%
D=12%[8%+1.0(16%8%)]=4.0%

20%8%=12%
18%8%=10%
17%8%=9%
12%8%=4%

StocksAandChavepositivealphas,whereasstocksBandDhavenegative
alphas.
Theresidualvariancesare:
2(eA)=582=3,364
2(eB)=712=5,041
2(eC)=602=3,600
2(eD)=552=3,025
b.

Toconstructtheoptimalriskyportfolio,wefirstdeterminetheoptimalactiveportfolio.
UsingtheTreynorBlacktechnique,weconstructtheactiveportfolio:
A
B
C
D
Total

0.000476
0.000873
0.000944
0.001322
0.000775

0.6142
1.1265
1.2181
1.7058
1.0000

Donotbeconcernedthatthepositivealphastockshavenegativeweightsandvice
versa.Wewillseethattheentirepositionintheactiveportfoliowillbenegative,
returningeverythingtogoodorder.

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Chapter 08 - Index Models

Withtheseweights,theforecastfortheactiveportfoliois:
=[0.61421.6]+[1.1265(4.4)][1.21813.4]+[1.7058(4.0)]
=16.90%
=[0.61421.3]+[1.12651.8][1.21810.70]+[1.70581]=2.08
Thehighbeta(higherthananyindividualbeta)resultsfromtheshortpositionsin
therelativelylowbetastocksandthelongpositionsintherelativelyhighbeta
stocks.
2(e)=[(0.6142)23364]+[1.126525041]+[(1.2181)23600]+[1.705823025]
=21,809.6
e=147.68%
Here,again,theleveredpositioninstockB[withhigh2(e)]overcomesthe
diversificationeffect,andresultsinahighresidualstandarddeviation.The
optimalriskyportfoliohasaproportionw*intheactiveportfolio,computedas
follows:
w0

/ 2 ( e)
16.90 / 21,809.6

0.05124
2
[E ( rM ) rf ] / M
8 / 23 2

Thenegativepositionisjustifiedforthereasonstatedearlier.
Theadjustmentforbetais:
w*

w0
0.05124

0.0486
1 (1 ) w 0 1 (1 2.08)(0.05124)

Sincew*isnegative,theresultisapositivepositioninstockswithpositivealphas
andanegativepositioninstockswithnegativealphas.Thepositionintheindex
portfoliois:
1(0.0486)=1.0486
c.

TocalculateSharpesmeasurefortheoptimalriskyportfolio,wecomputethe
informationratiofortheactiveportfolioandSharpesmeasureforthemarketportfolio.
Theinformationratiofortheactiveportfolioiscomputedasfollows:
A=/e)=16.90/147.68=0.1144
A2=0.0131
Hence,thesquareofSharpesmeasure(S)oftheoptimizedriskyportfoliois:
8

23

S 2 S 2M A 2

0.0131 0.1341

S=0.3662

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Chapter 08 - Index Models

ComparethistothemarketsSharpemeasure:
SM=8/23=0.3478
Thedifferenceis:0.0184
Notethattheonlymoderateimprovementinperformanceresultsfromthefactthat
onlyasmallpositionistakenintheactiveportfolioAbecauseofitslargeresidual
variance.
d.

Tocalculatetheexactmakeupofthecompleteportfolio,wefirstcompute`the
meanexcessreturnoftheoptimalriskyportfolioanditsvariance.Therisky
portfoliobetaisgivenby:
P=wM+(wAA)=1.0486+[(0.0486)2.08]=0.95
E(RP)=P+PE(RM)=[(0.0486)(16.90%)]+(0.958%)=8.42%

2P 2P 2M 2 (e P ) (0.95 23) 2 (0.0486 2 ) 21,809.6 528.94

P 23.00%

SinceA=2.8,theoptimalpositioninthisportfoliois:
y

8.42
0.5685
0.01 2.8 528.94

Incontrast,withapassivestrategy:
y

8
0.5401
0.01 2.8 23 2

Thisisadifferenceof:0.0284
Thefinalpositionsofthecompleteportfolioare:
Bills
M
A
B
C
D

10.5685=
0.5685l.0486=
0.5685(0.0486)(0.6142)=
0.5685(0.0486)1.1265=
0.5685(0.0486)(1.2181)=
0.5685(0.0486)1.7058=

43.15%
59.61%
1.70%
3.11%
3.37%
4.71%
100.00
%
[sumissubjecttoroundingerror]

NotethatMmayincludepositiveproportionsofstocksAthroughD.

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Chapter 08 - Index Models

18.

a.

Ifamanagerisnotallowedtosellshorthewillnotincludestockswithnegative
alphasinhisportfolio,sohewillconsideronlyAandC:

A
C

2(e)

1.6
3.4

3,364
3,600

0.000476
0.000944
0.001420

0.3352
0.6648
1.0000

Theforecastfortheactiveportfoliois:
=(0.33521.6)+(0.66483.4)=2.80%
=(0.33521.3)+(0.66480.7)=0.90
2(e)=(0.335223,364)+(0.664823,600)=1,969.03
e=44.37%
Theweightintheactiveportfoliois:
w0

/ 2 (e )
2.80 / 1,969.03

0.0940
2
E (R M ) / M
8 / 23 2

Adjustingforbeta:
w*

w0
0.094

0.0931
1 (1 ) w 0 1 [(1 0.90) 0.094]

Theinformationratiooftheactiveportfoliois:
A=/(e)=2.80/44.37=0.0631
Hence,thesquareofSharpesmeasureis:
S2=(8/23)2+0.06312=0.1250
Therefore:S=0.3535
ThemarketsSharpemeasureis:SM=0.3478
Whenshortsalesareallowed(Problem18),themanagersSharpemeasureis
higher(0.3662).ThereductionintheSharpemeasureisthecostoftheshortsale
restriction.

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Chapter 08 - Index Models

Thecharacteristicsoftheoptimalriskyportfolioare:
P=wM+wAA=(10.0931)+(0.09310.9)=0.99
E(RP)=P+PE(RM)=(0.09312.8%)+(0.998%)=8.18%
2P 2P 2M 2 (e P ) (0.99 23) 2 (0.09312 1,969.03) 535.54
P 23.14%

WithA=2.8,theoptimalpositioninthisportfoliois:
y

8.18
0.5455
0.01 2.8 535.54

Thefinalpositionsineachassetare:
Bills
M
A
C

b.

10.5455=
0.5455(10.0931)=
0.54550.09310.3352=
0.54550.09310.6648=

45.45%
49.47%
1.70%
3.38%
100.00
%
Themeanandvarianceoftheoptimizedcompleteportfoliosintheunconstrained
andshortsalesconstrainedcases,andforthepassivestrategyare:
E(RC)
Unconstrained
Constrained
Passive

0.56858.42=4.79
0.54558.18=4.46
0.54018.00=4.32

C2

0.56852528.94=170.95
0.54552535.54=159.36
0.54012529.00=154.31

Theutilitylevelsbelowarecomputedusingtheformula: E ( rC ) 0.005A C2
Unconstrained

8+4.79(0.0052.8170.95)=10.40

Constrained

8+4.46(0.0052.8159.36)=10.23

Passive

8+4.32(0.0052.8154.31)=10.16

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Chapter 08 - Index Models

19.

Allalphasarereducedto0.3timestheirvaluesintheoriginalcase.Therefore,the
relativeweightsofeachsecurityintheactiveportfolioareunchanged,butthealphaof
theactiveportfolioisonly0.3timesitspreviousvalue:0.316.90%=5.07%
Theinvestorwilltakeasmallerpositionintheactiveportfolio.Theoptimalrisky
portfoliohasaproportionw*intheactiveportfolioasfollows:
/ 2 (e )
5.07 / 21,809.6
w0

0.01537
2
E (rM rf ) / M
8 / 23 2

Thenegativepositionisjustifiedforthereasongivenearlier.
Theadjustmentforbetais:
w*

w0
0.01537

0.0151
1 (1 ) w 0 1 [(1 2.08) (0.01537)]

Sincew*isnegative,theresultisapositivepositioninstockswithpositivealphasanda
negativepositioninstockswithnegativealphas.Thepositionintheindexportfoliois:
1(0.0151)=1.0151
TocalculateSharpesmeasurefortheoptimalriskyportfoliowecomputetheinformation
ratiofortheactiveportfolioandSharpesmeasureforthemarketportfolio.The
informationratiooftheactiveportfoliois0.3timesitspreviousvalue:
A=/(e)=5.07/147.68=0.0343andA2=0.00118
Hence,thesquareofSharpesmeasureoftheoptimizedriskyportfoliois:
S2=S2M+A2=(8/23)2+0.00118=0.1222
S=0.3495
ComparethistothemarketsSharpemeasure:SM=8/23=0.3478
Thedifferenceis:0.0017
Notethatthereductionoftheforecastalphasbyafactorof0.3reducedthesquared
informationratioandtheimprovementinthesquaredSharperatiobyafactorof:
0.32=0.09
20.

Ifeachofthealphaforecastsisdoubled,thenthealphaoftheactiveportfoliowillalso
double.Otherthingsequal,theinformationratio(IR)oftheactiveportfolioalso
doubles.ThesquareoftheSharperatiofortheoptimizedportfolio(Ssquare)equalsthe
squareoftheSharperatioforthemarketindex(SMsquare)plusthesquareofthe
informationratio.Sincetheinformationratiohasdoubled,itssquarequadruples.
Therefore:Ssquare=SMsquare+(4IR)
ComparedtothepreviousSsquare,thedifferenceis:3IR
Nowyoucanembarkonthecalculationstoverifythisresult.

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Chapter 08 - Index Models

CFAPROBLEMS
1.

Theregressionresultsprovidequantitativemeasuresofreturnandriskbasedonmonthly
returnsoverthefiveyearperiod.
forABCwas0.60,considerablylessthantheaveragestocksof1.0.Thisindicates
that,whentheS&P500roseorfellby1percentagepoint,ABCsreturnonaveragerose
orfellbyonly0.60percentagepoint.Therefore,ABCssystematicrisk(ormarketrisk)
waslowrelativetothetypicalvalueforstocks.ABCsalpha(theinterceptofthe
regression)was3.2%,indicatingthatwhenthemarketreturnwas0%,theaverage
returnonABCwas3.2%.ABCsunsystematicrisk(orresidualrisk),asmeasuredby
(e),was13.02%.ForABC,R2was0.35,indicatingclosenessoffittothelinear
regressiongreaterthanthevalueforatypicalstock.
forXYZwassomewhathigher,at0.97,indicatingXYZsreturnpatternwasvery
similartotheforthemarketindex.Therefore,XYZstockhadaveragesystematicrisk
fortheperiodexamined.AlphaforXYZwaspositiveandquitelarge,indicatinga
returnofalmost7.3%,onaverage,forXYZindependentofmarketreturn.Residualrisk
was21.45%,halfagainasmuchasABCs,indicatingawiderscatterofobservations
aroundtheregressionlineforXYZ.Correspondingly,thefitoftheregressionmodel
wasconsiderablylessthanthatofABC,consistentwithanR2ofonly0.17.
Theeffectsofincludingoneortheotherofthesestocksinadiversifiedportfoliomaybe
quitedifferent.Ifitcanbeassumedthatbothstocksbetaswillremainstableovertime,
thenthereisalargedifferenceinsystematicrisklevel.Thebetasobtainedfromthetwo
brokeragehousesmayhelptheanalystdrawinferencesforthefuture.Thethree
estimatesofABCsaresimilar,regardlessofthesampleperiodoftheunderlyingdata.
Therangeoftheseestimatesis0.60to0.71,wellbelowthemarketaverageof1.0.
ThethreeestimatesofXYZsvarysignificantlyamongthethreesources,rangingas
highas1.45fortheweeklydataoverthemostrecenttwoyears.Onecouldinferthat
XYZsforthefuturemightbewellabove1.0,meaningitmighthavesomewhat
greatersystematicriskthanwasimpliedbythemonthlyregressionforthefiveyear
period.
Thesestocksappeartohavesignificantlydifferentsystematicriskcharacteristics.Ifthese
stocksareaddedtoadiversifiedportfolio,XYZwilladdmoretototalvolatility.

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Chapter 08 - Index Models

2.

TheR2oftheregressionis:0.702=0.49
Therefore,51%oftotalvarianceisunexplainedbythemarket;thisisnonsystematic
risk.

3.

9=3+(113)=0.75

4.

d.

5.

b.

8-14