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Chapter 10
Why Index models?
Identifying the tangency portfolio using the standard variance formula (as
before) can get complicated with lots of assets
!(r)"s # $
%
i
# $
ij
"s # ($
%
& $)'% (Why?)
(otal) ($
%
*+$)'%
With 100 ,ssets- need 10-+00'% # .1.0 pieces of information to plot all 100 assets
on an !(r) '
graph/
0actor models) ,llows a much easier way to calculate variances/
1ain idea) (here are ma2or economic forces that syste3matically move the prices
of all securities
& 4eturn on the mar5et portfolio (index)
& ?
& ?
0actor 1odel 6eneralities)
,ssume that actual returns are centered around what you expected- plus surprise
movements in some common factor- plus uni7ue firm movements)
i i i i
e F r E r + + ) (
(hin5 of ;eta as the extent of a stoc5"s mar5et ris5 & its average movement
when the mar5et moves)
%
) - (
M
M i
i
R R Cov
6uess the <icture
%
4
i
4
i
,
;
4
1
4
1
4
i
4
i
=
4
1
4
1
C
1ain >utcome of the ?ingle3Index 1odel
+
Cumulative returns
0.96
0.98
1
1.02
1.04
1.06
1.08
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Time
V
a
l
u
e
S&P500
Energy West
ATC Group
If we assume that actual returns can be bro5en down into systematic (i/e/
mar5et3related) and firm3specific parts- then variance also can be bro5en
down into two parts)
) (
% % % %
i M i i
e +
(he ?ingle3Index 1odel also gives us an easy way to calculate covariance
between two assets)
%
) - ( ) - (
M j i M j M i j i
R R Cov R R Cov
?uppose you are considering $ ris5y assets/ :sing the single index model- how
many pieces of information do you need to find the efficient frontier?
!(r)"s #
) (
M i i
r E +
%$ * 1
%
i
#
) (
% % %
i M i
e +
$ * 1
(otal) +$ * %
(hus- it"s a lot easier to figure out what the efficient frontier of ris5y assets is if
you use an index model/
!stimating an Index model
0or each day ' wee5 ' month- record the excess return of the stoc5 and the
excess return of the mar5et/ =o this for a long time (li5e a year) and then
plot all of the pairs of excess returns/
@
4
i
8Aine of ;est 0it9- or ?ecurity Characteristic Aine
slope #
i
e
4
1
i
(he slope of the line of best fit is the stoc5"s beta & when the mar5et moved
by 1B- on average this is how much the stoc5 moved
(he vertical distance of each point away from the line is the 8residual9- or e
i
the part of the stoc5"s return that was firm3specific (i/e/ was not related to
the mar5et moving/)
(he e
i
"s (8deviations9) can be calculated as
actual & predicted return (p/ %CD)
(he 843s7uare9 statistic tells you how well all of the points 8fit9 the line
(more on p/ +0.)
!x) 4egress 1icrosoft"s returns on the index (?E< .00)
Micro P S Micro Micro Micro
e R R + +
E
>r- dep var # intercept * slope (indep var) * residual
(otal return # ,vg return not * ?ensitivity of 1icrosoft * 1ovements
explained by m5t/ to the mar5et (
) uni7ue to 1icrosoft
.
movements
$ote) ,ccording to the C,<1 (and assumption of the mar5et model)- the intercept
FshouldF be e7ual to GeroH
Iariance of 4esiduals)
) (
%
Micro
e
6reater variance says that actual return is more li5ely to be different from
expected & estimate of firm3specific component of return/
?uppose we estimate the relationship between 1icrosoft and the ?E<.00 for five
years/ We get)
Micro
# 0/%C- Micro
# 1/1%
i i p
w
-
) ( ) (
% % %
i i p
e w e
?o Kow does =iversification Wor5?
=iversification doesn"t affect p
is additive-
portfolio
"s/
Ley point) If error terms are uncorrelated for all assets and sum to Gero- the
uni7ue ris5 for an e7ual weighted portfolio of many assets will become very
low)
Aet w
i
= 1/N for all i
(i/e/ we are constructing an e7ual3weighted portfolio)
(hen-
N
e
e
N N
e
N
e w e
i
i
i i i p
) (
) (
1 1
) (
1
) ( ) (
%
%
%
%
% % %
,
_
>utcome) 0or large $-
0 ) (
%
p
e
and the only remaining ris5 of portfolio is
mar5et ris5- i/e/
% % %
M p p
M
p
>utcome)
:ni7ue ris5
M p
333333333333333333333333333333333333333333333
(otal ris5 1ar5et ris5
$
?ummary
1ar5owitG approach) >b2ective is to maximiGe utility (i/e/ maximiGe return for a
given level of ris5 ' minimiGe ris5 for a given level of return) by choosing some
portfolio along the efficient frontier/
Kow do you 5now what the efficient frontier is ?? Calculate !(r)"s and
variances for all portfolios/ Iariances are the difficult part- because
covariances between all assets within the portfolio must also be calculated/
,fter points along efficient frontier are calculated- select an optimal portfolio
based on indifference curve"s tangency point/
?ingle Index model approach) ?ame ob2ectives- however simplifies (reduces) the
number of inputs necessary to calculate portfolio variances/
(he index model lets you calculate a beta & this can be used to calculate
expected returns using the C,<1/
Nou can then calculate the variance using the index model"s formula for
variance/
D
1ultiple 0actor 1odels (10/@)
<roblem with single3index model) 1ar5et movements actually don"t do
a very good 2ob of explaining movements in the average stoc5HH
Ley idea) (here are probably other factors that are common to
securities" non3systematic ris5 component of variance/
In other words- one common factor probably isn"t enough to explain 8mar5et
movements9)
1odel) t i t k k i t i t i i i
e F b F b F b a r
% % 1 1
/// + + + + +
0"s are small number of common factors (1- 5) for which different assets
have different sensitivities (the b"s)
With enough common factors- the residuals should now be truly firm3
specificH
(hin5 of common factors as representing new information about macroeconomic
information- i/e/ it is !O<!C(,(I>$? of future factor changes that matter/
1
1
n
i
i i P
w
+
1
1
n
i
i i P
w
+
1
1
% % %
) ( ) (
n
i
i i P
e w e
(he optimal ris5y portfolio based on the (n*1) ris5y assets maximiGes the
?harpe ratio/ (he actively managed component involves ta5ing a different
position than in the index- therefore is a departure against efficient
diversification/ (herefore- the weight of the actively managed part of the
portfolio is based on the incremental value it adds to the mar5et index (the
%
%
0
' ) (
) ( '
M M
R E
e
w
1%
Kigher (lower) levels of the active portfolio"s beta reduce (increase) the
diversification benefit of the passive portfolio (see footnote 1+)/ 0or
example if you find that
0
0
F
) 1 ( 1
w
w
w
+
$ow- the index component of the optimal (n*1) asset portfolio has a
weight of)
F F
1
M
w w
,nd the actively managed part (,) has a weighting of
F
w
- so that each
individual security within the actively managed portfolio has a weighting
of
i
w w F
0inally- go bac5 to the e7uation for the expected ris5 premium earlier in the
chapter- using a single index mar5et model)
(he expected ris5 premium of your overall portfolio (the n*1 assets based
on the actively analyGed n securities plus the index) is now)
) ( ) ( ) (
F F F
M !n"e# M P
R E w w w R E + +
) ( ) (
M P P P
R E R E +
1+
(he ris5 of the optimal portfolio is based on the index model portfolio ris5
e7uation)
) (
% % % %
P M P P
e +
Kere- substitute in beta and portfolio residual standard deviation and rewrite
as)
% F % % F F %
)Q ( R ) (
M !n"e# M P
e w w w + +
?ince you have calculated the overall weighting of the active portfolio in
con2unction with the index- the final step is to determine the individual
weightings of the n securities within the active portfolio/ It can be shown
that the ?harpe ratio of the combined (n*1) asset portfolio is related to the
?harpe ratio of the indexed part- plus the information ratio of the n3asset
active component)
%
% %
) (
1
]
1
M P
e
S S
(herefore- to maximiGe the ?harpe ratio of the overall portfolio- you need to
maximiGe the information ratio of the active portfolio (the part in brac5ets)/
,fter some algebra- the weighting is for each asset in the active portfolio)
n
i i
i
i
i
i
e
e
w w
1
%
%
F F
) (
) (