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ri = αi + βirm + ei
The term βirm represents the stock's return due to the movement of the
market modified by the stock's beta (βi), while ei represents
the unsystematic risk of the security due to firm-specific factors.
This last equation greatly reduces the computations, since it eliminates the
need to calculate the covariance of the securities within a portfolio using
historical returns and the covariance of each possible pair of securities in the
portfolio. With this equation, only the betas of the individual securities and the
market variance need to be estimated to calculate covariance. Hence, the
index model greatly reduces the number of calculations that would otherwise
have to be made for a large portfolio of thousands of securities.
The comparison of a stock's excess return can be plotted against the market's
excess return on a scatter diagram using linear regression to construct a line
that best represents the data points. This regression line, called the security
characteristic line (SCL), is a graph of both the systematic and the
unsystematic risk of a security. The intercept of the regression line is the
alpha of the security while the slope of the line is equal to its beta.
Hence, the alpha component and the residual risk tends toward zero as the
number of securities are increased, which reduces the single-index model
equation to the market return multiplied by the risky portfolio's beta, which is
what the Capital Asset Pricing Modelpredicts.
The decomposition of a stock's return into alpha and beta components allows
an investor to profit from stocks with positive alpha while neutralizing the risk
of the beta component. Suppose that a portfolio manager has identified,
through research, one or more securities that have positive alpha but the
manager also forecasts that the market may decline in the near future. The
positive alphas indicate that the stocks are mispriced, and, therefore, can be
expected to correct to their proper price in time.