OBJECTIVES
Introduction To Single Index Model
Single Index Model: Expected Return
Single Index Model: Variance & Standard Deviation
Single Index Model: Correlation & Covariance
Prepared by: Nur Liyana Mohamed Yousop
SINGLE INDEX MODEL
• This model was suggested by Markowitz and the Single-index Model was fully developed by Sharpe (1970), who
assumed that the covariances could be ignored.
• Previously, Markowitz full-covariance model allows us:
• to determine the portfolio expected return and risk
• to determine the optimal portfolio combinations
• However, there is a problem where;
• full-covariance model becomes burdensome as number of securities in a portfolio grows → too complex
• Therefore, Markowitz suggest to use an index model to simplify the calculations
Estimation Issues
For every asset class For example, for n = 50,
being considered for assets we need to
inclusion in the portfolio, calculate (or, more
we must estimate: precisely, estimate):
Results of portfolio • Expected returns
allocation depend on • Standard deviation n = 50 expected returns
the accuracy of the • Correlation coefficient
statistical inputs n = 50 variances
• Among entire set
of assets n (n – 1) / 2 = 1225
• With 100 assets, covariances
4,950 correlation in total, n (n +3) / 2 =
estimates 1325 estimates!
The input list (i.e., list of assets on the market) in the Markowitz portfolio
selection model is very important, determining the accuracy of finding How to reduce? →
“efficient” portfolios however, it involves a lot of calculations Single index model
Advantages of The Single Index Model
Reduces the number
Easier for security
of inputs for
analysts to specialize
diversification
The Single Index Model
Individual Security: Expected Return
The Model Hence Can Be Expressed By The Following Equation:
(ri − rf ) = i + i (rm − rf ) + ei
or equivalently, using excess returns ;
Ri = i + i Rm + ei
Where;
ri : is return to stock i
rf : is risk free rate (e.g T-bills)
Rm : is the return to the market portfolio
i : expected return of stock i if market’s excess return is zero
I : measures the sensitivity of a stock to stock market movements (COVi.m /σ2m)
eit : component of return due to unexpected firm-specific events or error term
The Single Index Model
Individual Security: Expected Return
(ri − rf ) = i + i (rm − rf ) + ei
or equivalently, using excess returns ;
Ri = i + i Rm + ei
• Divides Return into Two Components
• A Unique Part (Firm-specific), α i
• is a micro-event, affecting an individual company, but not all companies in general (e.g.,
strike or resignation of CEO)
• A Market-related Part, βi Rm
• is a macro-event, affecting all (or most) firms (e.g., inflation or oil prices)
The Single Index Model
Individual Security: Variance (Risk Of Expected Return)
• The variance of the rate of return on each stock can be decomposed into the components:
(1) β2i σ2m : The variance due to the common market factor (systematic risk)
(2) σ2ei : The variance due to firm-specific unanticipated event
• the formula can be simplified as following:
σi2 = βi2σ m
2 +σ2
ie Variance residual
i = COVi.m / σ2m
The Single Index Model
Portfolio: Expected Return & Risk
• Single index model for a portfolio of expected stocks return:
Rp = p + p Rm
• The variance of rp is:
Where;
= +
2
p
2
p
2
m
2
iep α p = ∑w i α i
β p = ∑w i β i
σ 2 iep = ∑w i 2 σ 2 ie
The Single Index Model
Portfolio: Covariance And Correlation
COVi,j = βiβjσ2m
• Covariance
ri,j = βiβjσ2m
• Correlation σiσj
The Single Index Model
Example 1:
Stock Q Stock R Stock S
Alpha 0.8 1.3 2.1
Beta 1.5 1.7 0.8
Residual Variance 9 12 5
If the return on market is 8% and the standard deviation for market is 6%, determine the:
i) expected return on each stock
ii) variance of each stock
iii) Assuming you invest 20% in stock Q, 30% in stock R and 50% in stock S, compute the
portfolio’s expected return and standard deviation
Example 2:
Security
A B C D
Alpha 1.5 2.0 1.0 0.5
Beta 0.6 0.8 1.5 1.2
Residual variance 4 6 10 8
Market return 10%
Market variance 25%
Based on the above data, assist Mr. Han in considering his investment by determining the:
i) expected return for each security.
ii) standard deviation for each security’s return.
iii) covariance of each possible pair of the securities.
iv) return and standard deviation of the portfolio if it is formed with equal weight of the securities.
Example 3:
Below is the available information on four securities for your analysis.
Securities
Clematis Daphne Euphorbia Fargesia
Alpha 2.10 1.80 0.90 1.60
Beta 1.70 0.80 1.20 0.60
Residual variance 8 5 6 3
Market risk premium 11%
Market risk 5%
T-Bill rate 3%
Calculate the:
i) expected return for each security.
ii) standard deviation for each security’s return.
iii) return and standard deviation of the portfolio if you invest 40 percent in Clematis and equal
investment in Daphne, Euphorbia and Fargesia.