CHAPTER 8: INDEX MODELS

1. What are the advantages of the index model compared to the Markowitz procedure for
obtaining an efficiently diversified portfolio? What are its disadvantages?

The Markowitz procedure and the Separation Property is what we used to first compute w1* to
determine P* (given the risk-free rates and the risk and return characteristics of the risky assets) and
then compute y* to determine C* (using the risk-free rate, the risk and return of the optimal risky
portfolio and risk aversion). The Separation Property refers to separating the choice of the weights
of the risky assets from the choice of the weight of the risk-free asset. See page 214.

Although we talked about it in lecture, we did not do a complete Index Model Optimization. The
procedure is described in the text starting on page 261.

The advantage of an index model optimization, compared to the Markowitz procedure, is the
reduced number of estimates required.

For N assets, the Markowitz procedure requires:

N Variance (or standard deviation) calculations: i2
(N2 N)/2 Covariance calculations: ij

The total is N + (N2 N)/2

In N = 25, then the number of estimates is 25 + (252 -25)/2 = 325

For the index model, we can compare each asset to the index. So solve for:
i2 = i2M2 + 2(i)
ij = ijM2

For N assets, the index procedure requires:

N Beta calculations: i
N Variance of the errors calculations: 2(i)
1 Expected return of the market estimate: E(rM)
1 Variance of the market estimate: M2

The total is 2 x N + 2
In N = 25, then the number of estimates is 50 + 2 = 52

In addition, the large number of estimates required for the Markowitz procedure can result in large
aggregate estimation errors when implementing the procedure.

Another advantage of using an index model is that the relationship between stocks and an index
(measured by i) may be more stable than the relationships between stocks (measured by ij).

1
 The disadvantage of the index model arises from the models assumption that return residuals are
uncorrelated and therefore can be ignored. This assumption will be incorrect if the index employed
omits a significant risk factor.

For example, we know that the single-index market model (essentially the CAPM) seems to omit
risk-factors associated with market-cap and relative price (growth or value stock).
In this case, the errors are correlated. Therefore the math that allows for the calculate of
i2 = i2M2 + 2(i) and ij = ijM2 does not work.

2. What is the basic trade-off when departing from pure indexing in favor of an actively managed
portfolio?

The trade-off between a managed portfolio (P) and a benchmark index (B) is the probability of
superior performance (E(rP rB)) versus certainty of additional management fees.

3. How does the magnitude of firm-specific risk affect the extent to which an active investor will
be willing to depart from an indexed portfolio?

In other words: Will high firm-specific risk keep an active investor in a diversified indexed portfolio
or would the investor prefer an individual stock?

Increased firm-specific risk (2(i)) reduces the extent to which an active investor will be willing to
depart from an indexed portfolio to buy individual stock.

The total risk for an individual stock is the sum of the index risk (the market index M) and the firm
specific risk: i2 = i2M2 + 2(i)

The total risk for the market index is M2

Recall that the investor is only compensated for incurring index risk (market risk) and is not
compensated for incurring firm specific risk, 2(i), since other investors can easily and without cost
eliminate that risk through diversification. Therefore the well-diversified (index-holding) investor
will pay more for the stock, decreasing the stocks return to compensate only for the index risk.

The greater the firm specific risk, the smaller the portion of total risk the holder of one stock is
compensated.

4. Why do we call alpha a nonmarket return premium? Why are high-alpha stocks desirable
investments for active portfolio managers? With all other parameters held fixed, what would
happen to a portfolio's Sharpe ratio as the alphas of its component securities increased?

The total risk premium is E(r) rf = + [E(rM) rf].

Sharpe ratio = [E(r) rf]/

2
 Alpha is called a nonmarket return premium because it is the portion of the risk premium that is
independent of market performance. It is the risk-adjusted excess return. An increase in will
increase E(r) rf but will not increase , so as alpha increases, the Sharpe ratio increases.

Since a portfolios alpha is the weighted average of the individual securities alphas, holding all other
parameters fixed, an increase in any one securitys alpha increases the portfolios Sharpe ratio.

5. A portfolio management organization analyzes 60 stocks and constructs a mean-variance

efficient portfolio using only these 60 securities.

(a) How many estimates of expected returns, variances, and covariances are needed to
optimize this portfolio?

n = 60 estimates of means
n = 60 estimates of variances
(n2 n)/2 = 1,770 estimates of covariances
1,890 total estimates

(b) If one could safely assume that stock market returns closely resemble a single-index
structure, how many estimates would be needed?

In a single index model: rirf=i+i(rMrf)+ei

Equivalently, using excess returns: Ri=i+iRM+ei
The variance of the rate of return on each stock can be decomposed into the components:
The variance for each stock in relation to the common market factor = i2M2
The variance for each stock due to firm specific events = 2(i)

Cov(ri , rj ) i jM2
In this model:
The number of parameter estimates is:

n = 60 estimates of the mean E(ri)

n = 60 estimates of the sensitivity coefficient i
n = 60 estimates of the firm-specific variance 2(i)
1 estimate of the market mean E(rM )
1 estimate of the market variance M
2

Therefore, in total, 182 estimates.

The single index model reduces the total number of parameter estimates from 1,890 to 182.

6. The market index has a standard deviation of 22% and the risk-free rate is 8%.
The following are estimates for two stocks:
Firm-Specific
Stock E(r) Standard Deviation = (i)
A 13% 0.8 30%

3
 B 18% 1.2 40%

(a) What are the standard deviations of stocks A and B?

The standard deviation of each individual stock is given by:

i = [i2M2 + 2(i)]
A = [(0.8)2(0.22)2 + (0.30)2] = 34.78%
B = [(1.2)2(0.22)2 + (0.40)2] = 47.93%

(b) Supposethatweweretoconstructaportfoliowithfollowingproportions:
StockA=30%,StockB=45%andTbills=20%.
Computetheexpectedreturn,standarddeviation,beta,andnonsystematicstandard
deviationoftheportfolio.

E(rP)=wAE(rA)+wBE(rB)+wfrf=(0.30)(0.13)+(0.45)(0.18)+(0.25)(0.08)=14.00%

P = wAA + wBB + wf f = (0.30)(0.8)+(0.45)(1.2)+00.78

p2 = p2M2 + 2(p)

where P M isthesystematiccomponentand (e P ) isthenonsystematiccomponent.

2 2 2

Sincetheresiduals(i)areuncorrelated,thenonsystematicvarianceis:
2(p) = wA22(A) + wB22(B) + wf22(f) = (0.30)2(0.30)2 + (0.45)2(0.40)2 + 0 = 0.0405

Theresidual(nonsystematic)standarddeviationoftheportfoliois:
(p) = (0.0405)1/2=20.12%

Thetotalvarianceoftheportfolioisthen:
2 2 2 2 2
p = [p M + (p)] = [(0.78) (0.22) + 0.0405] = 0.2645 = 26.45%

7. Consider the following two regression lines for stocks A and B in the following figure.

4
(a) Which stock has higher firm-specific risk?

The two figures depict the Security Characteristic Line (SCL) for each stock.
Stock A has higher firm-specific risk because the deviations of the observations from the SCL are
larger for Stock A than for Stock B. Deviations are measured by the vertical distance between each
point and the line.

(b) Which stock has greater systematic (market) risk

Market risk () is the slope of the SCL and measures of systematic risk. The SCL for Stock B is
steeper so Stock Bs systematic risk is greater.

(c) Which stock has higher R2?

R2 (or the squared correlation coefficient) is the ratio of the explained variance of the stocks
return to total variance.
Total variance is the sum of the explained variance plus the unexplained variance (the stocks
residual variance):
2 2 2 2
2 Explained Variance i M
R=
i = 2 = 2 2 i M2
Total Variance i i M+ ( i )

Since explained variance for stock B ( B M ) is greater than explained variance for stock A
2 2

(B > A) and residual variance for stock B (2(B )) is smaller, Bs R2 is higher than Stock As.

(d) Which stock has higher alpha?

Alpha is the intercept of the SCL with the vertical axis (the expected return axis). Stock A has a
small positive alpha. Stock B has a negative alpha. Stock As alpha is larger.

(e) Which stock has higher correlation with the market?

5
 The correlation coefficient is the square root of R2, so Stock Bs correlation with the market is
higher.

8. Consider the two (excess return) index model regression results for A and B:

RA = 1% + 1.2 RM RB = -2% + 0.8 RM

R2 = 0.576 R2 = 0.436
Residual Stdev = (A) = 10.3% Residual Stdev = (B)= 9.1%

(a) Which stock has higher firm-specific risk?

Firm-specific risk is measured by residual standard deviation = (i)

(A) > (B)
10.3% > 9.1%

(b) Which stock has greater systematic (market) risk

Market risk is measured by .

A > B
1.2 > 0.8

(c) Which stock has higher R2?

R2 measures the fraction of total variance of return explained by the market return.
As R2 > Bs R2
0.576 > 0.436

(d) If rf were constant at 6% and the regression had been run using total rather than excess
returns, what would have been the regression intercept for stock A?

Part(d)isdesignedtoshowingthealphawillbewrongifyoudonotsubtracttheriskfreebefore
doingtheregression.

RewritetheSCLequationintermsoftotalreturn(r)ratherthanexcessreturn(R):
rA rf = + (rM rf )
rA = + (rM rf ) + rf
rA = + rM rf + rf
rA = + rf rf + rM
rA = + rf (1 ) + r M
rA = [ + rf (1 )] + r M

Theslopeisstillbuttheintercept(inbrackets)isequalto:+rf(1
+ rf (1 ) = 1 + 0.06(1 1.2) = -0.2

6
Use the following data for Problems 9 through 14. Suppose that the index model for stocks A
and B is estimated from excess returns with the following result

RA = 3% + 0.7 RM + eA
RB = -2% + 1.2 RM + eB
M = 20%
R2A = 0.20
R2B = 0.12

9. What is the standard deviation of each stock?

Note that this is a text-book exercise to understand the relationship between R2 and i. If we are
able to compute the values given above, we could compute the standard devation of the stocks
returns. The standard deviation of each stock can be derived from the following equation for
R2:
2 2
2 Explained Variance i M 2 2i 2M
Ri = = 2 i = 2
Total Variance i Ri
2 2 2 2
( 0.7 ) ( 0.20 )
2A = A 2 M = =0.0980
RA 0.20

A = 31.30%

2 2B 2M ( 1.2 )2 ( 0.20 )2
= 2 =
B =0.4800
RB 0.12

B = 69.28%

10. Break down the variance of each stock to the systematic and firm-specific components

The systematic risk for A is: 2A 2M =( 0.7 )2 ( 0.20 )2=0.0196

The firm-specific risk of A (the residual variance) is the difference between As total variance
(calculated in question 9) and its systematic variance:

2A 2A 2M =0.0980=0.0196=0.0784

2 2 2 2
The systematic risk for B is: B M =( 1.2 ) ( 0.20 ) =0.0576

The firm-specific risk of B (the residual variance) is the difference between Bs total variance
(calculated in question 9) and its systematic variance:
2 2 2
B B M =0.4800=0.0576=0.4224

11. What are the covariance and correlation coefficient between the two stocks?

7
 2M =( 0.20 )2 =0.0400

2
Covar ( r A ,r B ) = AB= A B M = ( 0.70 )( 1.20 )( 0.0400 ) =0.0336

AB 0.0336
Correl ( r A , r B )= AB = = =0.155
A B ( 0.3130 )( 0.6928 )

12. What is the covariance between each stock and the market index?

Recall that correlation between the stocks and the market is the square root of regression R2. We are
given the two R2 values above.

Cov(rA,rM ) =AM = AMAM = (0.20)1/2(0.3130)(0.20) = 0.0280

Cov(rB,rM ) = BM = BMBM = (0.121/2)(0.6928)(0.20) = 0.0480

15. A stock recently has been estimated to have a beta of 1.24:

(a) What will a beta book compute as the adjusted beta of this stock?

Note that we did not cover adjusted betas in class, but it is fairly simple and I wanted to give you
a quick look at what is sometimes called the Merrill-Lynch adjusted Betas. Betas are adjusted
by taking the sample estimate of beta (the beta calculated in Excel) and averaging it with 1.0,
using the weights of 2/3 and 1/3 which moves it toward 1.0. The motivation for adjusting betas
toward 1.0 is that over time, as businesses grow, their betas move toward the market beta of 1.0.

Adjusted Beta at time t = t = (1/3)(1.0) + (2/3)t-1 = (1/3)(1.0) + (2/3)(1.24) = 1.16

(b) Suppose that you estimate the following regression describing the evolution of beta over
time: t = 0.3 + 0.7t-1.Whatwouldbeyourpredictedbetafornextyear?

t = (0.3)(1.0) + (0.7)1.24 = 1.168

CFAPROBLEMS

1. Theregressionresultsprovidequantitativemeasuresofreturnandriskbasedonmonthlyreturns
overthefiveyearperiod.

8
forABCwas0.60,considerablylessthantheaveragestocksof1.0.Thisindicatesthat,whenthe
S&P500roseorfellby1percentagepoint,ABCsreturnonaverageroseorfellbyonly0.60
percentagepoint.Therefore,ABCssystematicrisk(ormarketrisk)waslowrelativetothetypical
valueforstocks.ABCsalpha(theinterceptoftheregression)was3.2%,indicatingthatwhenthe
marketreturnwas0%,theaveragereturnonABCwas3.2%.ABCsunsystematicrisk(orresidual
risk),asmeasuredby(e),was13.02%.ForABC,R2was0.35,indicatingclosenessoffittothelinear
regressiongreaterthanthevalueforatypicalstock.
forXYZwassomewhathigher,at0.97,indicatingXYZsreturnpatternwasverysimilartothefor
themarketindex.Therefore,XYZstockhadaveragesystematicriskfortheperiodexamined.Alpha
forXYZwaspositiveandquitelarge,indicatingareturnofalmost7.3%,onaverage,forXYZ
independentofmarketreturn.Residualriskwas21.45%,halfagainasmuchasABCs,indicatinga
widerscatterofobservationsaroundtheregressionlineforXYZ.Correspondingly,thefitofthe
regressionmodelwasconsiderablylessthanthatofABC,consistentwithanR2ofonly0.17.
Theeffectsofincludingoneortheotherofthesestocksinadiversifiedportfoliomaybequitedifferent.
Ifitcanbeassumedthatbothstocksbetaswillremainstableovertime,thenthereisalargedifference
insystematicrisklevel.Thebetasobtainedfromthetwobrokeragehousesmayhelptheanalystdraw
inferencesforthefuture.ThethreeestimatesofABCsaresimilar,regardlessofthesampleperiodof
theunderlyingdata.Therangeoftheseestimatesis0.60to0.71,wellbelowthemarketaverageof
1.0.ThethreeestimatesofXYZsvarysignificantlyamongthethreesources,rangingashighas1.45
fortheweeklydataoverthemostrecenttwoyears.OnecouldinferthatXYZsforthefuturemight
bewellabove1.0,meaningitmighthavesomewhatgreatersystematicriskthanwasimpliedbythe
monthlyregressionforthefiveyearperiod.
Thesestocksappeartohavesignificantlydifferentsystematicriskcharacteristics.Ifthesestocksareadded
toadiversifiedportfolio,XYZwilladdmoretototalvolatility.

2. TheR2oftheregressionis:0.702=0.49
Therefore,51%oftotalvarianceisunexplainedbythemarket;thisisnonsystematicrisk.

3. 9=3+(113)=0.75

4. d.

5. b.