Investments, 8

th
edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 8
Index Models
8-2
Reduces the number of inputs for
diversification
Easier for security analysts to specialize
Common factor, m, macroeconomic variable
that affects all firms,
measures unanticipated macro surprises
Firm-specific factor, e
i
, uncertainty about the
firm in particular,
measures only firm-specific surprises
Advantages of the Single Index
Model
8-3

i
= sensitivity of a securities particular return to
the factor;
m = unanticipated movement related to security
returns;
e
i
= assumption: a broad market index like the
S&P 500 is the common factor.
Single-Factor Model
( )
i i i i
r E r m e | = + +
8-4
Single-Index Model
Regression Equation:


Historical sample of paired observations
Expected return-beta relationship:


Second term = Systematic risk premium,
while o
i
is a non-market return component
( ) ( ) ( )
t i t M i
R t R t e t o | = + +
( ) ( )
i i i M
E R E R o | = +
8-5
Single-Index Model Cont.
Risk and covariance:
Total risk = Systematic risk + Firm-specific
risk:
Covariance = product of betas x market index
risk:

Correlation = product of correlations with the
market index
2 2 2 2
( )
i i M i
e o | o o = +
2
( , )
i j i j M
Cov r r | | o =
2 2 2
( , ) ( , ) ( , )
i j M i M j M
i j i M j M
i j i M j M
Corr r r Corr r r xCorr r r
| | o | o | o
o o o o o o
= = =
8-6
Index Model and Diversification
Portfolios variance:


Systematic and nonsystematic risk component
Variance of the equally weighted portfolio of
firm-specific components:


When n gets large, becomes negligible
2
2
2 2
1
1 1
( ) ( ) ( )
n
P i
i
e e e
n n
o o o
=
| |
= =
|
\ .

2 2 2 2
( )
P P M P
e o | o o = +
2
( )
P
e o
8-7
Figure 8.1 The Variance of an Equally
Weighted Portfolio with Risk Coefficient

p
in the Single-Factor Economy
8-8
Figure 8.2 Excess Returns on HP and
S&P 500, April 2001 March 2006
8-9
Figure 8.3 Scatter Diagram of HP, the
S&P 500, and the Security Characteristic
Line (SCL) for HP
8-10
Table 8.1 Excel Output: Regression
Statistics for the SCL of Hewlett-Packard
8-11
Figure 8.4 Excess Returns on Portfolio
Assets
8-12
Alpha and Security Analysis
Input list preparation
Macroeconomic analysis is used to estimate
the risk premium and risk of the market index
Statistical analysis is used to estimate the
beta coefficients of all securities and their
residual variances,
2
( e
i
)
They are used to establish the market-driven
expected return can be used as a
benchmark
8-13
Alpha and Security Analysis Cont.
The market-driven expected return is
conditional on information common to all
securities
Security-specific expected return forecasts
(alpha) are derived from various security-
valuation models
The alpha value distills the incremental risk premium
attributable to private information
The end result is the list of alpha values
Helps determine whether a security is a good or
bad buy
8-14
Single-Index Model Input List
If we combine n actively researched firms
and a passive market index portfolio, the
input list will include:
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
8-15
Optimal Risky Portfolio of the Single-
Index Model
The objective is to maximize the Sharpe ratio
Expected return, SD, and Sharpe ratio of
the portfolio are:
1 1
1 1
1
2
2 1
1 1
2 2 2 2 2 2
2
1 1
( ) ( ) ( )
( ) ( )
( )
n n
P P M P i i M i i
i i
n n
P P M P M i i i i
i i
P
P
P
E R E R w E R w
e w w e
E R
S
o | o |
o | o o o | o
o
+ +
= =
+ +
= =
= + = +
(
| |
(
= + = + (
|

\ . (

=


8-16
Optimal Risky Portfolio of the Single-
Index Model Cont.
The optimal portfolio is a combination of:
Active portfolio denoted by A;
Market-index portfolio, the (n+1)th asset
which we call the passive portfolio and
denote by M
Modification of active portfolio position:


Notice that when
0
*
0
1 (1 )
A
A
A A
w
w
w |
=
+
* 0
1,
A A A
w w | = =
8-17
The Information Ratio
The Sharpe ratio of an optimally constructed
risky portfolio (using w
A
* and w
A
o
) will exceed
that of the index portfolio (the passive
strategy):



The term in brackets is called information
ratio. It maximizes the overall Sharp ratio.
2
2 2
( )
A
P M
A
e
s s
o
o
(
= +
(

8-18
Figure 8.5 Efficient Frontiers with the
Index Model and Full-Covariance Matrix
8-19
Table 8.2 Comparison of Portfolios from
the Single-Index and Full-Covariance
Models
8-20
Table 8.3 Merrill Lynch, Pierce, Fenner &
Smith, Inc.: Market Sensitivity Statistics
8-21
Table 8.4 Industry Betas and Adjustment
Factors (Rosenberg and Guy, 1976)