Market and Index Models

Session 08

Outline 08: Market and Index Models

1. 2. 3. 4. CAPM and Multifactor Models Bloomberg Screen Components of Variance Diversification Effects 5. 6. 7. 8. Precision of Historical Betas Adjusting Historical Betas Estimating Expected Returns Market-Neutral Strategies (Problem Set)

Mandatory Reading: Hansells article.

CAPM and Multifactor Models

In the previous section we saw that in a CAPM framework the only variable that matters for asset pricing is the return of the market portfolio. Consider the following statistic representation of asset returns:
Rj = E Rj 1 2 3

( )

+ innovation in j's return 1444 4 24444 3

new information

expected component

We can also distinguish two broad types of innovations: systematic (generated by an arbitrarily large set of factors, K) and idiosyncratic.
R j = E R j + j1F1 + j 2 F2 + .... + jK FK + 14444 4 244444 3
systematic innovation (aggregate risk factors )

( )

idiosyncratic innovation (unique risk )

We end up with the following linear factor model of asset returns:

R j = a j + j1 F1 + j 2 F2 + .... + jK FK + j
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Now we can interpret the CAPM as a model in which returns are generated by a single factor:

R j = a j + j1F1 + j 2 F2 + .... + jK FK + j 14444 4 244444 3

j RM

More specifically, the Market Model1 is defined as:

R j = a j + j RM + j , j = 1, , N E j RM = E j = 0, j E i j = 0
This is, for instance, the model used by Bloomberg.

The label market model is often used for a model in which only (1) and (2) hold and the term single index model for the model in which (3) also holds. We will just use the latter. 2 Copyright Jos M. Marn Portfolio Management

Market and Index Models

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Market Model in the industry: Bloomberg screen

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Components of Variance
Consider the Market Model:

R j = a j + j RM + j
The market model provides a decomposition of the variance of an assets return into two components o market-related o non-market Using the regression, we obtain
var{Ri ,t } = cov{Ri ,t , Ri ,t } = cov{ i + i Rm,t + i ,t , i + i Rm,t + i ,t } =
market-related variance

(1)

142 4 43 4

i2 var{Rm,t }

non -market variance

var{ i ,t } 1 4 2 4 3

The R2 (R-squared) gives the fraction of the assets total variance that can be attributed to its marketrelated variance:

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Market and Index Models

Session 08

R =
2

i2 var{Rm,t }
var{Ri ,t } var{ i ,t } var{Ri ,t }

=1

(2)

In the Bloomberg example: o = 0.865 o std. dev.{CB,t} = 4.476% o R2=0.324 o Using (2):
R2 = 1 (0.04476) 2 = 0.324 Var ( RCB )

o std. dev.{RCB,t} = 5.43% Beta is not the same as R2: high-beta stocks can actually have lower correlations with the market.

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Market and Index Models

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Diversification Effects
A market-model regression also holds for a portfolio of assets. To see how: o Begin with a market-model regression for each of N assets in the portfolio o Multiply both sides of the regression equation for asset i by the portfolios weight in asset i, xi o Sum the resulting equations across the N assets
xi Ri ,t = xi ( i + i Rm,t + i ,t )
i =1 N N

n =1

R p ,t = p + p Rm,t + p ,t ,

where
p = xi i ,
i =1
N i =1

p = xi i ,
i =1

p ,t = xi i ,t .

The single-index model implies that the variance of returns on well-diversified portfolios will consist primarily of the market-related component.
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For example, with an equally weighted portfolio ( xi = 1/N ),

N 1 var{ p ,t } = var i ,t i =1 N 1 = var{ i ,t }, N

which approaches zero as N grows large. Therefore, the variance of the total portfolio return is
2 var{R p ,t } = p var{Rm,t } + 2 p var{Rm,t },

1 var{ i ,t } N

and the market-model R2 for the portfolio approaches 1. The single-index model also implies that well diversified portfolios will be highly correlated with each other.

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Market and Index Models

Session 08

Precision of Historical Betas

, is often referred to as the historical beta. A historical beta is a The OLS regression estimator of i, denoted i is given random variable, since it is computed from realizations of random returns. The standard error of i (approximately) by
2 i = 1 R s i m T

( )

(3)

Thus, (3) suggests that the precision of an OLS beta estimate can be increased by increasing the number of i . observations (T), or using portfolios instead of individual securities, thereby raising R2 and lowering For example, the equally weighted portfolio of the 30 Dow (1993-99, 84 months): Beta (raw) R2 Std. Error of Beta

Jones Industrial stocks gives the following results 1.05 0.93 0.03

Some experiments suggest that, in estimating historical betas using monthly returns, a sample period of five to seven years gives the optimal tradeoff between greater accuracy arising from a larger number of observations and lower accuracy arising from changes over time in the true underlying beta. Precision in historical betas can, in principle, be improved by increasing the frequency of return observations.
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Adjusting Historical Betas for Regression to the Mean

Denote the historical betas on asset i estimates in two adjustment five-year sample period as i ,(1) and i ,( 2 ) . For a number of assets (is), plot i ,(1) versus i ,( 2 ) .

As the plot suggests, the assets with extreme values (large or small) of i ,(1) tend to have values of i ,( 2 ) closer to 1.

This regression tendency can be represented by the fitted line in the above plot,
i ,( 2 ) = c0 + c1 i ,(1) ,

where it must be the case that

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c0 + c1 = 1. In practice, the raw historical betas are often adjusted toward 1 to account for this regression tendency. The adjusted beta estimator, , is formed by
ADJ ,i = w 1 + (1 w) i .

A typical specification (e.g., Bloomberg) sets w = 1/3.

Estimating Expected Returns: Why Bother with Beta?

Based on the past 84 months of data, you estimate the mean and volatility of the return on a given stock, Ri,t, and the return on the S&P in excess of the riskless (T-Bill) rate, rm = RSP ,t R f ,t . Mean Ri rm 1.5% 0.5 Std. Dev. (s) 13.3% 4.8

Using the simple historical average return, you would estimate the stocks expected return as 1.5%.

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Assuming that the current T-Bill return is 0.3% monthly, and the stocks estimated beta equals 1.41, the CAPMbased estimate is
Ei* = 0.3 + 1.41(0.5) = 1.01%

The CAPM approach combines estimates of two unknown quantities: the expected excess market return and beta, and the CAPM could be wrong. Is it worth the trouble? Compare the standard errors of the two estimates: greater precision lower standard error For historical mean:
std. error = s 13.3 = = 1.45% T 84

For CAPM-based estimates:

r = 0.76% std.error = std. dev. m

Why? Greater precision in the estimated market risk premium, rm , outweighs the effect of additional . estimation error in
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Allows substantial error in the CAPM pricing relation before the CAPM-based estimate of expected return becomes less precise. Even greater differences arise between approaches if the market equity premium is based on a longer sample period than used for the individual stocks average return.

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Market Neutral Strategies

(Read Articles in the reading list)
Market-Neutral Strategies. The following questions are based on the assigned reading, The Other Side of Zero, by Saul Hansell, which appeared in the April 1992 issue of International Investor. 1. Explain why the market-neutral strategy is described as two-alpha, no beta. 2. On page 59 (middle column, bottom), Salomons Sorensen is quoted as saying The volatility of the marketneutral funds isnt 16 percent like the S&P, but 5 to 10 percent. The last paragraph on page 60 begins with the statement, Of course, any strategy that doubles up on its alpha has, by definition, twice the risk. The two alphas represent a form of leverage, says Unisys Service. a) What prediction can one make, if any, about the volatility of a market neutral strategy? Upon what will the volatility depend? b) If a market-neutral position is constructed by combining (1) a long position in a portfolio of oil stocks with a beta of 1.2 and an annual volatility (standard deviation) of 30% with (2) a short position in S&P 500 index futures, what is the volatility of the return on the market-neutral position? Assume that the annual rate of return on the S&P 500 index has a volatility of 16%, and ignore margin deposits on the futures position (assume there are none). 3. On page 62 (middle column, bottom), the article reasons that though the managers are investing in stocks, this can hardly be considered equity, because the product is hedged. With a legitimate benchmark of the T-bill rate, a long-short equity strategy is in fact most appropriate as an alternative to other investments.

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a) Do you agree that the market neutral strategies should best be viewed as alternatives to cash? b) What would justify the statement that the T-bill rate is a legitimate benchmark for market-neutral strategies? c) Would you recommend a market neutral strategy to a client with a negative short-term view of the equity market? (see the quote from Mr. Borneman of Consolidated Gas) 4. Suppose the true expected excess return on a market-neutral strategy is zero, and the annual volatility of the strategy is 10%. a) What is the probability of observing a (simple arithmetic) average excess annual return over two years greater than 19 percent? b) What is the probability of observing a five-year average excess annual return greater than 10%? c) If there are 24 such market neutral strategies, and the returns on the strategies are independent of each other, what is the probability that at least one of the strategies will achieve the performance in part a.? In part b.? (see page 59, middle column, middle paragraph)

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