CHAPTER 8

Index Models

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Overview
• Advantages of a single-factor model
• Risk decomposition
– Systematic vs. firm-specific
• Single-index model and its estimation
• Optimal risky portfolio in the index model
– Index model vs. Markowitz procedure

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Advantages of the Single Index Model
• Reduces the number of inputs for
diversification

• Easier for security analysts to specialize

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 Single Factor Model
r𝑖 = 𝐸[𝑟𝑖 ] + 𝛽𝑖 𝑚 + 𝑒𝑖
Where:
𝛽𝑖 response of an individual security’s return to
the common factor m.
Beta measures systematic risk.
𝑚 a common macroeconomic factor that
affects all security returns.
The S&P500 is often used as a proxy for 𝑚
𝑒𝑖 firm-specific surprises

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 Single-Index Model
Regression Equation:

𝑅𝑖 𝑡 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑀 𝑡 + 𝑒𝑖 𝑡

The expectation of the residual term 𝑒𝑖 is zero,

so the expected return-beta relationship is:

𝐸 𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 𝐸 𝑅𝑀

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 Single-Index Model
Risk and covariance:
• Variance - Systemic risk and firm-specific
risk, assume noise is uncorrelated:
      (ei )
i
2
i
2 2
M
2

• Covariance - product of betas x market index

risk:
Cov(ri , rj )  i  j 2
M

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 Single-Index Model - Correlation
Product of correlations with the market index:

Corri , j ri , rj   Covi , j ri , rj  /  i j 

 i  j 2
M
Corri , j ri , rj  
2
 
M

 i j  M M
 i M  j M
 Corr ri , rM  Corr rj , rM 
2 2

 i M  j M
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 Questions to test your intuition
• What is the stock’s E[𝑟] if (𝑟𝑀 −𝑟𝑓 ) = 0 ?
• What is the responsiveness of the stock to
market movements relative to 𝑟𝑓 ?
• What is the stock-specific component of
return (not driven by the market)?
• What is the variance attributable to
uncertainty of the market?
• And that attributable to firm-specific events?

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 Index Model and Diversification
• Consider an Equally weighted portfolio and
take the expected return 𝑅𝑃 as the average:

1 n 1 n
RP   Ri    i   i RM  ei 
n i 1 n i 1
1 n 1 n 1 n
   i    i RM   ei
n i 1 n i 1 n i 1

RP   P   P RM  eP

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 Index Model and Diversification
• The portfolio variance by definition:
𝜎𝑃2 = 𝛽𝑃2 𝜎𝑀
𝑃
+ 𝜎 2 (𝑒𝑃 )

• where the market component comes from the

portfolio’s sensitivity to the market:
1 n
 P   i
n i 1
• and the non-systemic component 𝜎 2 (𝑒𝑃 ) is
the contribution of all the stocks in the
portfolio.

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 Index Model and Diversification
• Variance of the non-systemic component of
an equally weighted portfolio is (we assume
all the stock-specific components are
uncorrelated):
𝑛 2
2
1 2
1 2
𝜎 (𝑒𝑃 ) = 𝜎 (𝑒𝑖 ) = 𝜎 (𝑒)
𝑛 𝑛
1
• When n gets large, 𝜎 2 (𝑒𝑃 ) becomes
negligible and firm specific risk can be
diversified away.
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 Figure 8.1 The Variance of an Equally
Weighted Portfolio with Risk Coefficient βp

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Fig 8.2 Excess Returns on HP and S&P500

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Fig 8.3 Scatter Diagram of HP, the S&P 500,
and HP’s Security Characteristic Line (SCL)
RHP t    HP   HP RSP 500 t   eHP t 

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Table 8.1 Excel Output: Regression Statistics
for the SCL of Hewlett-Packard

 correlation
 explanatory power

(monthly)




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 Table 8.1 Interpretation
• Correlation of HP with the S&P500 is 0.7238
• The model explains about 52% of the
variation in HP
• HP’s alpha is 0.86% per month (10.32% pa),
but it is not statistically significant
Q. What does it mean? Why?
• HP’s beta is 2.0348, but the 95% confidence
interval (which is +/- ~2 standard errors) is
quite wide (~2 x 0.25 = 0.5)

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Figure 8.4 Excess Returns on Portfolio Assets

• Study pairs of securities

vs the market to
estimate correlations
• Compute stats to
measure correlations

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Study portfolio stats – 1

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A closer look at correlations

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Study portfolio stats – 2

 i  j 2
M

    ei 
2
i
2
M
2

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Example: build optimal portfolio

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 Alpha and Security Analysis
1. Use Macroeconomic analysis to estimate
risk premium and risk of the market index
(𝑅𝑀 , 𝜎𝑀 )

2. Use statistical analysis to estimate the

beta coefficients of all securities and their
residual variances 𝜎 2 (𝑒𝑖 )

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 Alpha and Security Analysis
3. Use numerical methods to establish the
expected return of each security
independently of security analysis (𝛽)

4. Use security analysis to develop your own

forecast of the expected returns for each
security (𝛼)

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 Single-Index Model considerations
• Techniques for estimating 𝛽 are well
known
• Estimating alpha requires a deep
knowledge of the company behind the
stock:
– Positive 𝛼 means overweight in the
portfolio
– What do you do if 𝛼 is negative?

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Recall the Minimum-Variance Frontier

Chapter 7
took the
entire
universe of
stocks and
used
brute-force
math to
find the
efficient
frontier

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 Single-Index Model – Optimization

• Single-Index model offers a simpler

optimization than the model in chapter 7
as the model is simplified
• Include the market as asset n+1 to
improve diversification. By definition:
– Beta of market index = 1
– Alpha of market index = 0
– emarket_index = 0

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 Single-Index Model Input List

• Risk premium on the S&P500 portfolio

(𝑅𝑀 )
• Estimate of the SD of the S&P500
portfolio (𝜎𝑀 )
• n sets of estimates (one set for each stock)
of:
–Beta coefficient
–Stock residual variances
–Alpha values
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 Single-Index Model steps
• Use RM, alphas and betas to construct n+1
expected returns
• Use betas and 𝜎𝑀 to construct the covariance
matrix
• Set up the optimization problem to minimize
portfolio variance, given a return, subject to…
• …constraint that weights add up to one
• You could use excel solver to solve this
problem and build your efficient frontier

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 Index Model – Recall 𝛼𝑃 and 𝛽𝑃

Consider a generic portfolio and take the

excess return RP as the average:
n n
RP   wi Ri   wi  i   i RM  ei 
i 1 i 1
n n n
  wi i   wi  i RM   wi ei
i 1 i 1 i 1

RP   P   P RM  eP

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 Optimal Risky Portfolio of the
Single-Index Model
Now take the portfolio expected
excess return:

E RP   P  E RM   P
n n
  wi i  E RM  wi  i
i 1 i 1

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 Optimal Risky Portfolio of the
Single-Index Model
Standard Deviation and Sharpe Ratio:

 
2
P  2
P   2
M   eP  2

2
 n
 2 n
   wi  i   M   wi  ei 
2 2

 i 1  i 1

S P  E RP  /  P
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 Optimal Risky Portfolio of the
Single-Index Model
• No need to use Excel as there is an
analytical solution
• Solution is a combination of:
–Active portfolio (A), with weight wA
–Market-index passive portfolio (M)

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 Optimal Risky Portfolio - wA
Assume for a moment beta=1
Then the optimal weight wA is proportional to
the ratio 𝜎𝐴 /𝜎 2 (𝑒𝐴 ) to balance excess return
and residual variance from Active portfolio A:

A
 e A 
2
w 
0
A
E RM 
 2
M

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 Optimal Risky Portfolio of the
Single-Index Model
Next, modify of active portfolio weight wA to
optimize, as beta is not necessarily =1:
0
w
w 
* A
1  1   A wA
A 0

Notice that when

 A  1 then w  w*
A
0
A

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 The Information Ratio
The Sharpe ratio of an optimally constructed risky
portfolio will exceed that of the index portfolio (the
passive strategy):
2
2 2
𝛼𝐴
𝑆𝑃 = 𝑆𝑀 +
𝜎 𝑒𝐴 Information
Ratio
Information Ratio
• The contribution of the active portfolio depends on
the ratio of its alpha to its residual standard deviation
• The information ratio measures the extra return we
can obtain from security analysis
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Figure 8.5 Efficient Frontiers with the Index
Model and Full-Covariance Matrix

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Table 8.2 Portfolios from the Single-Index
and Full-Covariance Models

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 Is the Index Model Inferior to the
Full-Covariance Model?
Full Markowitz model may be better in
principle, but:
• Using the full-covariance matrix invokes
estimation risk of thousands of terms
• Cumulative errors may result in a portfolio
that is actually inferior to that derived from the
single-index model
• The single-index model is practical and
decouples macro and security analysis.

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Beta Book: Industry Version of the Index
Model
• Use 60 most recent months of price data
• Use S&P500 as proxy for M
• Compute total returns that ignore dividends
• Estimate index model without excess
returns:
r  a  brm  e *

instead of
r  rf     rm  rf   e
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 Beta book – alpha and intercept

• The intercept is different in the two

formulas. Rewrite as:
r  rf    rm  rf  e
r  rf 1       rm  e
If* rf is constant you have same 𝛽 and 𝑒.
The intercept a is an estimate for
rf 1     
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 Beta Book: Industry Version of the Index
Model
• The average beta over all securities is 1.
Thus, our best forecast of the beta would be
that it is 1.
• Also, firms may become more “typical” as
they age, causing their betas to approach 1.

Adjust beta because:

 adjusted  2 3  sampled  13 1

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Table 8.4 Industry Betas and
Adjustment Factors

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