Investment Analysis & Portfolio Management

Index Models
Reference: Investments, by Bodie, Kane & Marcus,
McGraw Hill Education, Ch-8
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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A Single-Factor Market
• Advantages
• Reduces the number of inputs for diversification
• Easier for security analysts to specialize
• Model
ri  E ri    i m  ei
• βi = response of an individual security’s return to
the common factor, m; measure of systematic risk
• m = a common macroeconomic factor
• 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
• Variance = Systematic risk + Firm-specific
risk:
      ei 
i
2
i
2 2
M
2

• Covariance = Product of betas × 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

i  j 2
i  j
2 2

Corr  ri , rj   M
 M M

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

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Index Model and Diversification
• Variance of the equally-weighted portfolio of
firm-specific components:
2

 e p       ei    e
2
n
1 2 1 2
i 1  n  n

• When n gets large, σ2(ep) becomes negligible

and firm specific risk is diversified away

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The Variance of an Equally Weighted Portfolio
with Risk Coefficient βp

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Excess Returns on HP and S&P 500

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Scatter Diagram of HP, the S&P 500, and HP’s SCL

RHP t    HP   HP RS & P 500 t   eHP t 

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

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

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Excess Returns on Portfolio Assets

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Portfolio Construction and the Single-Index Model
• 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, σ2(ei).
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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Portfolio Construction and the Single-Index Model

• Single-Index Model Input List

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

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Portfolio Construction and the Single-Index Model

• Optimal risky portfolio in the single-index

model
• Expected return, SD, and Sharpe ratio:

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Portfolio Construction and the Single-Index Model

• Optimal risky portfolio in the single-index

model is a combination of
• Active portfolio, denoted by A
• Market-index portfolio, the passive
portfolio, denoted by M

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Portfolio Construction and the Single-Index Model

• The Information Ratio

• The Sharpe ratio of an optimally constructed risky
portfolio will exceed that of the index portfolio
(the passive strategy):

2
 A 
s P  s M   (eA ) 
2 2

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Portfolio Construction and the Single-Index Model

• 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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Efficient Frontiers with the Index Model and Full-
Covariance Matrix

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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
decentralizes macro and security analysis

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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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Industry Version of the Index Model
• Adjust beta because
• The average beta over all securities is 1; thus, the
best forecast of the beta would be that it is 1
• Firms may become more “typical” as they age,
causing their betas to approach 1

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Predicting Beta
• Current Beta = a + b(past beta)

• Forecast beta = a +b(Current beta)

• Current beta = a + b1(Past beta) + b2(Firm

size) + b3 (Debt ratio)

• Also, variance of earnings, variance of case

flow, Growth in earning per share may be
helpful to predict beta.
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Industry Betas and Adjustment Factors

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Thank You!

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