The Single index model

The Inputs to Portfolio Analysis (Markowitz Model)

• The expected return on any • The data necessary to

portfolio
perform portfolio analysis
N
for N securities
• Rp = X
i 1
i Ri
• Number of estimates of expected
return of each security =N
• SD of return on any portfolio
• Estimates of variance of each
security =N
1/ 2
N N N
 • Estimates of correlations between
 P   X i2 i2   X i X j  ij  each possible pair of securities
 i 1 i 1 j 1
 = N(N-1) /2
 i j 
• Risk free rate = 1
•
Total = (N2 + 3N + 2)/2
 The Inputs to Portfolio Analysis (Sharpe’s Model)

• Portfolio return • The data necessary to

perform portfolio analysis
R P   X i Ri for N securities
Ri  i  i R m • Number of estimates of α for
RP  P  P Rm each stock = N
X    P and  X i  i   P • Number of estimates of β for
i i
each stock = N
• Number of estimates of ei2 for
• Portfolio variance each stock = N
• Number of estimates of Market
return and market variance =2
 P2   P2 m2   X i2 ei2 • Risk free rate = 1
• Total number of estimates
• = 3N+3
 The data necessary to perform portfolio analysis

Number of security Markowitz Sharpe

(N) (N2 + 3N + 2)/2 3N+N
10 66 33
30 496 93
100 5151 303
• Casual observation of stock prices reveals
that when the market goes up, most
stocks tend to increase in price, and when
the market goes down, most stocks tend
to decrease in price.
 Figure-1: Relationship between the returns on an
individual company and the returns in the market portfolio.

• Stock return Ri

• 15 .
• …. . error

• ....
• .…..
• …..
• . …. .
• . error
• . . 2
• . . .
• .. -4 Market return 12 Rm
.
• The return on a stock can be written as:
• Ri = ai + iRm
• Where ai = i + ei
• ei = Random Errors
• E(ai) = i

• Thus, Ri = i + iRm + ei

• where, Ri = Rate of return to a security or portfolio and

• Rm = Rate of return to a market portfolio.
• The model assumes that two types of events
produce the period to period variability in stock’s
rate of return.
•
Events
•
Macro Event Micro Event (Firm Specific)
• (i) Inflation Strikes
• (ii) Interest Rate Discovery of a new product
• (iii) Market condition Obsolescence of an old one
• Macro events affect all firms and they have an
effect on the general level of stock price (market
index).

• Thus in Figure 1, if the return to the market

portfolio in a given period were equal to -4%, we
would expect the return to the stock to be 2%. If
the market return is 12%, we would expect
individual stock’s return to be 15%.

• The variation of individual return caused by

regression line is systematic variation or
systematic risk, which is measured by .
• Micro Events affect the individual firm alone. The
variation caused by micro events is called unsystematic
risk ei. These events cause the appearance of residuals
or deviation from the characteristic lines.
• These events affect the individual firm alone. They are
assumed to have no effect on other firms, and they have
no effect on the value of the market portfolio or its rate of
return.
• Since micro events have no effects on other firm, the
residuals or shocks terms for different companies are
assumed to be un-correlated with one another, as
depicted in Figure 2.
• i.e., Cov. (eit, ej,t) = 0

• Since the micro events have no impact on market return

• Cov. (ei, Rm) = 0
• Or 1/n [ei (Rm – E(Rm))] = 0
 Figure 2: Relationship between residuals on stocks i and j

• Residual for stock i, ei

• .
• . . .
• . . . .
• . . . Residual for stock j, ej
• .
• Two Assumptions:

• E(eiej) = 0

• E [ei (Rm – E(Rm))] = 0

• Basic Equation:
• Ri = i + iRm + ei

• By construction
• Mean of ei = E (ei) = 0

• By Assumption:
• E[ei {Rm – E(Rm)}] = 0
• E(eiej ) = 0 [i.e., Securities only related to through common response to
market].

• By Definitions:
• Variance of ei = ei2
• Variance of Rm = m2
• We can derive the expected return,
standard deviation and covariance as
follows:

• (1) E(Ri) = i + iE(Rm)

• (2) i2 = i2 m2 + ei2
• (3) ij = ijm2
The mean return E(Ri) = i + i(Rm)

• We know,
• Ri = i + iRm + ei
•  Ri = [i + iRm + ei]
• 1/n  Ri = 1/n [i + iRm + ei ]
• E(Ri) = [i + iE(Rm) + 1/nei]
• E(Ri) = i + iE(Rm)
 i2 = i2 m2 + ei2

• We know
• i2 = 1/n [Ri – E(Ri)]2
• i2 = 1/n [i + iRm + ei – i – iE(Rm)]2
• i2 = 1/n [i {Rm – E(Rm)} + ei]2
• i2 = 1/n [i2 {Rm – E(Rm)}2 + 2 i {Rm – E(Rm)}ei + ei2]
• i2 = i2 m2 + 2i 1/n  {Rm – E(Rm)}ei + 1/n ei2
• i2 = i2 m2 + ei2 [Since 1/n  {Rm – E(Rm)}ei = 0]
 ij = ijm2
• ij = 1/n {(Ri – E(Ri)}{Rj – E(Rj)}
• ij = 1/n [i {Rm – E(Rm)} + ei] [j {Rm – E(Rm)} + ej]
• ij = ijm2 + i 1/n  {Rm – E(Rm)} ej + j 1/n  {Rm –
E(Rm)} ei + 1/n eiej
• ij = ijm2
• Since, the last three terms are zero by assumption
• CHARACTERISTICS OF THE SINGLE-INDEX MODEL

• Portfolio Beta
• βp = Σ Xi βi

• Portfolio Alpha
• p = Σ Xi i
R P   X i Ri
Ri   i  i R m

R P   X i i  i Rm 
R P   X i i   X i  i R m
RP   P   P Rm
( If R P  R m ; P  0; and P  1; The portfolio is the Market Portfolio)
X i i   P and  X i  i   P
• The Beta on the market is 1 and stocks
are thought of as being more or less risky
than the market, according to whether the
Beta is larger or smaller than 1
• β=1
• β>1
• β < 1.
 β=1

• Ri

• Rm
 β > 1 [Aggressive stock]

• Ri

• Rm
 β < 1 [Defensive stock]

• Ri

• Rm
• We have shown that we can split the variance of the
return on a security or portfolio into two parts:

• i2 = i2 m2 + ei2

• p2 = p2 m2 + ep2

• Total variance = Systematic risk + Residual risk

 We know the variance of a portfolio.

N N
   X    X i X j ij
2
P i
2
i
2

i 1 j 1
i j

   X       X i X j  i  j m2
N N
2 2 2 2 2
P i i m ei
i 1 j 1
i j
N N N
   X     X    X i X j  i  j m2
2
P i
2
i
2 2
m i
2 2
ei
i 1 i 1 j 1
i j
N N
   X i X j  i  j m2   X i2 ei2
2
P
i 1 j 1

 N  N 
    X i  i   X j  j  m2   X i2 ei2
2
P
 i 1  j 1 
 P2   P2 m2   X i2 ei2
 N

• ep2 = 
i 1
X 2σ 2
i ei

• Portfolio residual variance

• = “Weighted average” of security residual variances
where portfolio weights are squared
• Consider the residual variance formula,
and suppose we have a large number of
securities, each with a residual variance
equal to 10%.
• If we invest half our money equally in two of the
securities, the residual variance of the two-security
portfolio is 5% according to the foregoing formula.
• ep2 =(.502 x .10) + (.502 x .10) =.05

• In the same sence, if we invest a third of our money in

each of three of securities, the residual variance of the
portfolio would be 3.33 % and so on, as shown by the
blue curve in the following figure.
The relationship between the residual variance and the
number of securities in the portfolio
Portfolio residual variance

Number of stocks in portfolio

If equal amount of funds are invested in
each security,

    X 
2
P
2
P
2
m i
2 2
ei

1  2
    
2
P
2
P
2
m
ei
N N
1 2
 P   P m   ei
2 2 2

N
 2
• If N is very large, then 1/N  = 0 and Residual risk
ei
i.e., unsystematic risk is diversified away.

• Therefore,

  
2
P
2
P
2
m

 P   P m
 N

 P   m  X i  i 
 i 1 
• In an efficient portfolio total portfolio risk is only
systematic risk.
• Since, m is the same, regardless of which stock
we examine, the measure of the contribution of a
security to the risk of a large portfolio is i.

• i2 = i2 m2 + ei2

• Since, ei2 can be diversified away, i is often
used as a measure of a security’s risk.
• i is the security’s non-diversification risk.
• Numerical Examples:
• Consider two securities A and B.
• A = 1.2 B = 1.1
• eA = 2.76% eB = 6.06%
• eA2 = 7.61 eB2 = 37
• Assume, m = 8, then m2 = 64
• Find out the values of A2 and B2
• A2 = A2 m2 + eA2
• =(1.2)2 x 64 + 7.61
• =92.16+7.61= 99.73
• B2 = B2 m2 + eB2
• = (1.1)2 x 64 + 37
• = 77.44+37 =114.44

• RA > RB ?
• RA < RB ?
• If equal amount is invested in each securities what is the
portfolio variance P2?

• P2 = P2m2 + eP2 = P2m2 + Xi2ei2

• Now, P = (0.5) (1.2) + (0.5) (1.1) = 0.6 + 0.55 = 1.15
• eP2 = Xi2ei2 = [(0.5)2 x 7.61] + [(0.5)2 x 37]
• = 1.9025 + 9.25 = 11.15
•  P2 = (1.15)2 (64) + 11.15 =
• =84.64 + 11.15 = 95.79
 Calculation of ,  and Residual Variance:
X = BSE monthly rate of return
Y = Colgate Palmolive monthly rate of return.

{X-E(X)} {Y-E(Y)}
X Y {X-E(X)} {Y-E(Y)} {X-E(X)}2

0.123 0.1564 0.0677 -0.1708 -0.01156 0.00458

-0.100 0.1161 -0.1553 -0.2111 0.03278 0.02411
.237 0.5300 0.1817 0.2028 0.03685 0.03301
0.108 0.2944 0.0527 -0.0328 -0.00172 0.00277
-0.083 0.1277 -0.1383 -0.1995 0.02759 0.01912
0.028 0.3103 -0.0273 -0.0169 0.00046 0.00074
0.142 0.5355 0.0867 0.2083 0.01805 0.0075
0.173 0.6008 0.1177 0.2736 0.0322 0.01385
-0.130 0.2736 -0.1853 -0.0536 0.00993 0.03433
X = 0.498 Y = 2.9448
 = 0.14458  = 0.14001

E(X) = E(Y) =
0.0553
0.3272
 1
n
  
X  X Y Y 
0.14458
   1.032
1
n
 X  X
2
 0.14001

Ri     R m
  R i   R m  0.3272  (1.03)(0.0553)  0.27
 ei = Yi – ( + Xi)

 + Xi ei = Yi – ( + Xi) ei2

0.396936 -0.24054 0.05786

0.1668 -0.0507 0.00257
0.51458 0.0154 0.00024
0.3812 -0.0868 0.00753
0.1845 -0.0568 0.00322
0.2988 0.0115 0.00013
0.41626 0.11924 0.01422
0.4482 0.1526 0.02328
0.1361 0.1375 0.01890
ei2 = 1/n ei2 = 0.12795/9 = 0.0142
 i2   i2 m2   ei2
 i2  (1.032) 2 (0.01555)  0.0142  0.01656  0.0142  0.03074
• [Since  m2  1/n  [X – E(X)] 2  1/9 (0.14001)  0.01555]

{Y-E(Y)} {Y-E(Y)}2

-0.1708 .02917264
-0.2111 .04456321
0.2028 .04112784
-0.0328 .00107584
-0.1995 .03980025
-0.0169 .00028561
0.2083 .04338889
0.2736 .07485696
-0.0536 .00287296
Σ {Y-E(Y)}2 = .277142
Var of Y = 1/n Σ {Y-E(Y)}2
= (1/9) (.277142) = 0.03079
 Relation between r (correlation between individual
security’s return and market return) and unsystematic risk

• σ i2 = β i2 σ m2 + σei2
• 1 = (β i2 σ m2 / σ i2 ) + (σei2/ σ i2 )
• 1 = R2 + (un systematic Risk/Total Risk)
• 1= R2 + .0142 / .03074
• Or, R2 = 1- .4619 = .538
• r = +0.734

• (β i2 σ m2 / σ i2 ) = [(σ im/ σ m2)2 x (σ m2) / σ i2 )]

• (β i2 σ m2 / σ i2 ) = (σ im2/ σ m2 σ i2) = [σ im/ σ i σ m)2]
• (β i2 σ m2 / σ i2 ) = R2
 Multifactor Models
• Formally, a single factor model is
described by the following equation
• ri = E(ri) + βi F + ei ……..(1)

• Suppose that the macro factor, F, is the

unexpected percentage change in GDP,
and that the consensus is that GDP will
increase by 4% this year.
• Also suppose that a stock’s β value is 1.2.
• If GDP increases by only 3%, then F= -1%
But if GDP increase by 5%, F= 1%.
• This macro surprise, together with the
firm-specific disturbance, ei, determines
the total departure of the stock’s return
from its originally expected value.
• Suppose you currently expect the above
stock to earn a 10% rate of return. Then
some macroeconomic news suggests that
GDP growth will come in at 5% instead of
4%.
• Stock’s expected rate of return =
• 10% +1.2 (5%-4%) = 11.2%
• When we motivated the single index
(factor) model, we noted that the
systematic risk arises from a number of
sources
• Examples are uncertainty about the
business cycle, interest rates, inflation,
and so on.
• When we estimate a single-index
regression, therefore, we implicitly impose
an (incorrect) assumption that each stock
has the same relative sensitivity to each
risk factor.
• If we allow the possibility of the fact that
different stocks exhibit different
sensitivities to its various components, we
may constitute a more useful multifactor
model.
• It is easy to see that multifactor models –
can provide better descriptions of security
returns.
 Two-factor model

• Suppose the two sources of risk are

unanticipated growth in GDP and
unexpected changes in interest rates.
• The two factor model can be written as
follows:
• ri = E(ri) + βiGDP GDP + βiIR IR +ei …… (2)
• βiGDP and βiIR are called factor betas.
• Consider two firms, one a regulated electric-
power utility in a mostly residential area, the
other an airline.
• Because residential demand for electricity is not
very sensitive to the business cycle, the utility is
likely to have a low beta on GDP.
• But utility’s stock price may have a relatively
high sensitivity to interest rates. Why?
• Conversely, the performance of the airline
is very sensitive to economic activity but is
less sensitive to interest rates.
• It will have a high GDP beta and a lower
interest rate beta.
• Suppose that on a particular day, there is
a piece of news suggesting that the
economy will expand. GDP is expected to
increase, but so are interest rates.
• Is the “macro news” on this day good or
bad?
• For the Utility, this is bad news.
• But for the airline, this is good news.

• Clearly a one-factor or single-index model

cannot capture such differential responses
to varying sources of macroeconomic
uncertainty.
 Risk Assessment Using Multifactor Models

• Suppose, we estimate the two-factor

model in equation (2) for Jet Airways and
find the following result:
• ri = 0.2 + 2.2(GDP) + 0.6(IR) +ei