CHAPTER 8

Index Models

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McGraw-Hill/Irwin

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Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

8-2

Advantages of the Single Index

Model
Reduces the number of inputs for
diversification
Easier for security analysts to specialize

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8-3

Single Factor Model

ri E (ri ) i m ei
i = response of an individual securitys return
to the common factor, m. Beta measures
systematic risk.
m = a common macroeconomic factor that
affects all security returns. The S&P 500 is
often used as a proxy for m.
ei = firm-specific surprises
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Single-Index Model
Regression Equation:

Ri t i i RM t ei t

Expected return-beta relationship:

E Ri i i E RM

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Single-Index Model
Risk and covariance:
Variance = Systematic risk and Firmspecific risk: 2
i i2 M2 2 (ei )
Covariance = product of betas x market
index risk:
2
Cov(ri , rj ) i j M

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Single-Index Model
Correlation = product of correlations with
the market index
i j
Corr (ri , rj )
i j

2
M

i j

Corr (ri , rM ) xCorr (rj , rM )

i M j M
2
M

2
M

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Index Model and Diversification

Variance of the equally weighted portfolio of
firm-specific components:
2

1 2
1
2
(eP ) (ei ) (e)
n
i 1 n
2

When n gets large, 2(ep) becomes

negligible and firm specific risk is diversified
away.
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8-8

Figure 8.1 The Variance of an Equally

Weighted Portfolio with Risk Coefficient p

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Figure 8.2 Excess Returns on HP and

S&P 500

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8-9

Figure 8.3 Scatter Diagram of HP, the S&P

500, and HPs Security Characteristic Line
(SCL)

RHP t HP HP RS & P 500 t eHP t

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Table 8.1 Excel Output: Regression

Statistics for the SCL of HewlettPackard

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8-12

Table 8.1 Interpretation

Correlation of HP with the S&P 500 is 0.7238.
The model explains about 52% of the variation in
HP.
HPs alpha is 0.86% per month(10.32%
annually) but it is not statistically significant.
HPs beta is 2.0348, but the 95% confidence
interval is 1.43 to 2.53.

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Figure 8.4 Excess Returns on

Portfolio Assets

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8-14

Alpha and Security Analysis

1. Use macroeconomic analysis to estimate the
risk premium and risk of the market index.
2. Use statistical analysis to estimate the beta
coefficients of all securities and their residual
variances, 2 (ei).

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8-15

Alpha and Security Analysis

3. Establish the expected return of each
security absent any contribution from
security analysis.
4. Use security analysis to develop private
forecasts of the expected returns for each
security.

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Single-Index Model Input List

Risk premium on the S&P 500 portfolio
Estimate of the SD of the S&P 500
portfolio
n sets of estimates of
Beta coefficient
Stock residual variances
Alpha values

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8-17

Optimal Risky Portfolio of the

Single-Index Model
Maximize the Sharpe ratio
Expected return, SD, and Sharpe
ratio:
n 1

n 1

i 1

i 1

E ( RP ) P E ( RM ) P wi i E ( RM ) wi i

P (eP )
2
P

2
M

1
2

wi i w (ei )
i 1
i 1

2
M

n 1

n 1

2
i

1
2

E ( RP )
SP
P
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Optimal Risky Portfolio of the

Single-Index Model
Combination of:
Active portfolio denoted by A
Market-index portfolio, the passive
portfolio denoted by M

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Optimal Risky Portfolio of the

Single-Index Model
Modification of active portfolio position:
0
w
A
w*A
1 (1 A ) wA0

When

A 1, w w
*
A

0
A

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8-19

8-20

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
A

s P s M (eA )

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The 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 SingleIndex 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
decentralizes macro and security analysis.
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8-24

Beta Book: Industry Version of the

Index Model
Use 60 most recent months of price data
Use S&P 500 as proxy for M
Compute total returns that ignore
dividends
Estimate index model without excess
returns:
*

r a brm e

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8-25

Beta Book: Industry Version of the

Index Model

Adjust beta
because:

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.
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Table 8.4 Industry Betas and

Adjustment Factors

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