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    Lecture 4 Index Model and CAPM

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    noobmaster 0206
    The document provides an overview of the single-index model and the Capital Asset Pricing Model (CAPM). It discusses how the single-index model reduces inputs for diversification and measures systematic risk through beta. It also explains how CAPM is derived from principles of diversification and portfolio optimization. Under CAPM, the expected return of an asset is equal to the risk-free rate plus its beta times the expected market risk premium. The document includes figures illustrating the security market line and how a positive-alpha stock relates to the SML.

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    Lecture 4 Index Model and CAPM

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    noobmaster 0206
    8 views17 pages
    The document provides an overview of the single-index model and the Capital Asset Pricing Model (CAPM). It discusses how the single-index model reduces inputs for diversification and measures systematic risk through beta. It also explains how CAPM is derived from principles of diversification and portfolio optimization. Under CAPM, the expected return of an asset is equal to the risk-free rate plus its beta times the expected market risk premium. The document includes figures illustrating the security market line and how a positive-alpha stock relates to the SML.

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    lecture 4

    Original Title

    Lecture 4 Index model and CAPM

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    The document provides an overview of the single-index model and the Capital Asset Pricing Model (CAPM). It discusses how the single-index model reduces inputs for diversification and measures systematic risk through beta. It also explains how CAPM is derived from principles of diversification and portfolio optimization. Under CAPM, the expected return of an asset is equal to the risk-free rate plus its beta times the expected market risk premium. The document includes figures illustrating the security market line and how a positive-alpha stock relates to the SML.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    8 views17 pages

    Lecture 4 Index Model and CAPM

    Uploaded by

    noobmaster 0206
    The document provides an overview of the single-index model and the Capital Asset Pricing Model (CAPM). It discusses how the single-index model reduces inputs for diversification and measures systematic risk through beta. It also explains how CAPM is derived from principles of diversification and portfolio optimization. Under CAPM, the expected return of an asset is equal to the risk-free rate plus its beta times the expected market risk premium. The document includes figures illustrating the security market line and how a positive-alpha stock relates to the SML.

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    © All Rights Reserved
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    Download as pdf or txt
    of 17

    FMT – IPM

    Lecture 5:
    Chapter 8: SINGLE INDEX MODEL
    Chapter 9: CAPITAL ASSET PRICING
    MODEL

    Ms. Phuong Pham, MSc


    Lecture outline
    • Advantages of a single-factor model
    • Risk decomposition
    • Systematic vs. firm-specific
    • Single-index model and its estimation
    • Optimal risky portfolio in the index model
    • Index model vs. Markowitz procedure
    1 SINGLE FACTOR
    MODEL
    Single index model

    • Advantages
    • Reduces the number of inputs for
    diversification
    • Easier for security analysts to specialize
    • Model ri = E (ri ) + bi m + ei
    • βi = response of an individual security’s return
    to the common factor, m; measure of
    systematic risk
    • m = a common macroeconomic factor
    • ei = firm-specific surprises
    Single-Index Model

    • Regression equation:
    Ri (t ) = a i + bi RM (t ) + ei (t )
    excess return (Rt) = r - rf

    • Expected return-beta relationship:


    E (Ri ) = a i + bi E (RM )

    •
    Single-Index Model
    • Variance = Systematic risk + Firm-specific risk:

    s = b s + s (ei )
    i
    2
    i
    2 2
    M
    2

    • Covariance = Product of betas × Market index risk:

    Cov ( ri , rj ) = bi b js 2
    M

    • Correlation = Product of correlations with the market index


    bi b js M2 bis M2 b js M2
    Corr ( ri , rj ) = =
    s is j s is M s js M
    = Corr ( ri , rM ) ´ Corr ( rj , rM )
    Index Model and
    Diversification
    • Variance of the equally-weighted portfolio of
    firm-specific components:
    2

    s (e p ) = å ç ÷ s (ei ) = s (e )
    2
    n
    æ1ö 2 1 2
    i =1 è n ø n
    • When n gets large, σ2(ep) becomes negligible
    and firm specific risk is diversified away
    Excess Returns on Figure 8.2
    HP and S&P 500
    Scatter Diagram of HP, the Figure 8.3
    S&P 500, and HP’s SCL

    SCL

    RHP (t ) = a HP + b HP RS &P500 (t ) + eHP (t )


    Output: Regression Statistics
    for the SCL of HP
    Interpreting the Output

    • Correlation of HP with the S&P 500 is 0.7238


    • The model explains about 52% of the
    variation in HP
    • HP’s alpha is 0.86% per month (10.32%
    annually) but it is not statistically significant
    • HP’s beta is 2.0348, but the 95% confidence
    interval is 1.43 to 2.53
    2 Capital Asset Pricing
    Model
    Capital Asset Pricing Model
    (CAPM)

    • It is the equilibrium model that underlies all


    modern financial theory
    • Derived using principles of diversification with
    simplified assumptions
    • Markowitz, Sharpe, Lintner and Mossin are
    researchers credited with its development
    Assumptions

    • Investors optimize portfolios a la Markowitz


    • Investors use identical input list for efficient
    frontier
    • Same risk-free rate, tangent CAL and risky
    portfolio
    • Market portfolio is aggregation of all risky
    portfolios and has same weights
    CAPM

    [
    E (rGE ) = rf + b GE E (rM ) - rf ]
    • CAPM holds for the overall portfolio because:
    E ( rP ) = å wk E ( rk ) and
    k

    b P = å wk b k
    k
    • This also holds for the market portfolio:
    E ( rM ) = r f + b M éë E ( rM ) - r f ùû
    The Security Market Line Figure 9.2
    The SML and a Positive-
    Alpha Stock

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