Scribd
Upload
28 views12 pages

Chapter 8 Portfolio

Chapter 8 notes Fin 363

Uploaded by

namocap329
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
28 views12 pages

Chapter 8 Portfolio

Chapter 8 notes Fin 363

Uploaded by

namocap329
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 12

Chapter 8: Index Models

There are two models to reach the optimal risky portfolio:


1- Markowitz Model
2- Index Model
Both models have the same goal, which is to reach the optimal risky portfolio.

Drawbacks to Markowitz procedure (Covariance Matrix)


1- Requires a huge number of estimates to fill the covariance matrix. (Finding
a lot of covariances which is not optimal)
2- Model does not provide any guidelines for finding useful estimates of these
covariances or the risk premiums
Which is why the index model is introduced.

Introduction of index models


1- Simplifies estimation of the covariance matrix
2- Enhances analysis of security risk premiums

A Single-Factor Security Market

Advantages of the single-index model


1- Number of estimates required is a small fraction of what would otherwise
be needed. (Less estimates than the covariance matrix)
2- Specialization of effort in security analysis

Single factor means the only outside factor the security is exposed to is the
market.

Where m= Market factor that measures unanticipated developments in the


macroeconomy.
This is not the single-index model, but this is what it’s based on
Return on portfolio is a function of:
1- Expected return on the portfolio
2- Beta * Market return
3- Residual risk (firm-specific risk)

Single Index Model

Regression Equation (Monthly)

This is the single-index model

It’s a function of: (where returns come from)


1- Excess return over the market return (alpha)
2- Beta*Market returns
3- Firm specific risk

Expected return-beta relationship

The difference between this and the single index model is that this doesn’t include
residual when calculating the expected return. Why?
Because we assume that when we construct portfolio, we diversity enough to
eliminate the firm-specific risk. However, this doesn’t apply when we calculate the
actual return because we need to include firm-specific risk because the risk isn’t
eliminated in reality. But when calculating expectation, we include expectation of
good diversification.

Total risk = Systematic risk + Firm-specific risk

Covariance = Product of betas × Market-index risk

Correlation = Product of correlations with the market index


Index Model and Diversification

Variance of the equally weighted portfolio of firm-specific components:

When n gets large, σ2(ep) becomes negligible (Firm-specific)


As diversification increases, the total variance of a portfolio approaches the
systematic variance

The Variance of an Equally Weighted Portfolio with Risk Coefficient, βp

You’re still exposed to the systematic risk even when n gets large.
This graph shows that Amazon is more volatile than the market. It means that the
value of beta is very high. Therefore, you should be rewarded with a return that is
compensating you for the extra volatility.

In October 2013 the return of market is 4% but Amazon is 16.4%. If I only hold
Amazon in my portfolio I will be exposed to the total firm-specific risk. However,
when I diversify, I will be able to reduce firm specific risk.
Security Characteristic Line (SCL)

R(t)= Actual return- Rf, and you can get it using the above equation too.

You can measure market returns through an index like S&P 500.
You calculate alpha, beta, and e through regression.
So, you take returns of security and regress it over return on the market.
This Is index model

R-Square: How much returns of market explain the return of my security. (Low in
this case)
Standard-error: Firm-specific risk.
Coefficients:
1- Intercept: Alpha (excess return over market is 1.92%)
2- Market Index: Beta (1.5326 and is more volatile than market)

Industry Version of Index


You have to make expectations about securities (Beta, alpha, e)

Predicting betas
Betas tend to drift to 1 over time

Rosenberg and Guy found the following variables to help predict betas:
1- Variance of earnings (Higher = Increase Beta)
2- Variance of cash flow (Higher = Increase Beta)
3- Growth in earnings per share (If high = Decrease Beta)
4- Market capitalization (firm size) (Larger = Decrease Beta because it’s not
risky because it’s mostly stable)
5- Dividend yield (Higher = Decrease Beta)
6- Debt-to-asset ratio (Higher = Increase Beta)
Adjusted beta will always be larger than the raw beta because it’s adjusted for
debt. So, adjusted beta is better.

This is the industry version of the index model


This equation is the CAPM.
CAPM is a function of:
1- Risk free rate
2- Beta * Risk premium
It doesn’t take firm specific risk into account because it’s a passive strategy and it
assumes diversification. There is no alpha too because you can’t earn abnormal
returns over market.
Because the only return you earn is compensation for market risk and the
minimum return.
Portfolio Construction and the Single-Index Model

Alpha and security analysis


1- Macroeconomic analysis used to estimate the risk premium and risk of the
market index
2- Statistical analysis used to estimate beta coefficients and residual variances,
σ2(ei), of all securities
3- Establish expected return of each security absent any contribution from
security analysis
4- Security-specific expected return forecasts are derived from various
security-valuation models

Single-index model input list:


1- Risk premium on the S&P 500 portfolio
2- Standard deviation of the S&P 500 portfolio
3- n sets of estimates of: (If I have 100 securities I need to have 100 betas ets..)
-Beta coefficients
-Stock residual variances
-Alpha values

Multiply each value by weights. Goal is to find portfolio that maximizes Sharpe
ratio, which is tangent point between steepest CAL and Efficient Frontier.

Portfolio Construction: The Process


Optimal risky portfolio in the single-index model is a combination of two
component portfolios:
1- Active Portfolio denoted by A. Includes active analysis in the portfolio. You
try to beat the market.
2- Market-index portfolio (Passive), denoted by M. You copy an index so no
analysis. It’s not considered risk-free. Why? Because systematic risk.

Optimization Procedure

The passive portfolio does not have an alpha value because it doesn’t generate
excess return over market.
The more risk averse I am, the more weight will be put into the passive portfolio.

Optimal Risky Portfolio

Information Ratio

The contribution of the active portfolio depends on the ratio of its alpha to its
residual standard deviation (Step 5).

Information Ratio: How much excess return you can get based on firm-specific risk
you’re taking.
Calculated as the ratio of alpha to the standard deviation of diversifiable risk
The information ratio measures the extra return we can obtain from security
analysis.

If it’s high, then I can generate high excess return over market given a specific
level of firm-specific risk. Sharpe ratio measures excess return over the market
given a specific level of risk.

It gives me an indication of analytical abilities of portfolio managers.


If portfolio manager has good analytical skills to generate returns above market
returns and to choose securities that maximize returns over market returns or not.
Sharpe Ratio

The Sharpe ratio of an optimally constructed risky portfolio will exceed that of the
index portfolio (the passive strategy). Because if I didn’t then I’d just invest in the
passive portfolio because I wouldn’t be getting compensated for the extra risk I’m
exposed to.

Sharpe ratio of portfolio= Sharpe of Market + Information Ratio.


Higher excess returns = Higher Sharpe ratio

Efficient Frontier is set of portfolios that gives me highest return over specific level
of risk or lowest risk over specific level of return.

From this graph, Index model


can provide me with a set of
portfolios that has a lower risk
with the same level of returns
as the full covariance model
gives me.
However, when we reach the
Optimal Risky Portfolio the two
models will reach similar
portfolios. So, it will be one of
the sets at the upper right.
They both have similar risk premium, standard deviation, and Sharpe ratio.

Is the Index Model Inferior to the Full-Covariance Model?

Full Markowitz model is better in principle, but


The full-covariance matrix invokes estimation risk of thousands of terms
Cumulative errors may result in a portfolio that is actually inferior
The single-index model is practical and decentralizes macro and security analysis.
(When you do the model, you have market risk and returns, and you already have
macro analysis when you estimate expected returns of the market)

Both are important to reach ORP.

You might also like