CHAPTER 8 Index Models ‘While this portfolio is still risky (due to the residual risk, ey), the systematic risk has been eliminated, and if P is ly well-diversified, the remaining nonsystematie risk will be small. Thus the objective is achieved: the manager can take advantage of the 4% alpha \without inadvertently taking on market exposure. The process of separating the search for alpha from the choice of market exposure is called alpha transport This “long-short strategy” is characteristic of the activity of many hedge funds. Hedge fund managers identify an underpriced security and then try to attain a “pure play” on the perceived underpricing. They hedge out all extrancous risk, focusing the bet only ‘on the perceived “alpha’ (see the box on p. 272). Tracking funds are the vehicle used to Hiedge the exposures to which they do nor want exposure, Hedge fund managers use index regressions such as those discussed here, as well as more-sophisticated variations, (0 cre ae the tracking portfolios at the heart of their hedging strategies. 1, A single-facor model of the economy clases sources of unceriinty a systematic (macro- economic) fectors or firm-specific (microeconomic) factors. The index model assumes thatthe macro factor ean be represented by abroad index of sock returns “The single-index model dastially reduces the necessary inputs inthe Markowitz portfolio selee- tion proeeduce, I also sis in specialization of lahor i Security analy According to the index model specification, the systematic Fisk ofa portfolio or asst equals ru}, andthe covariance between two ase equals Bo ‘The index model is estimated by aplying regression analysis o exces fates of return. The slope of the regression curve is the hel of an asset, whereas the intercept isthe asset's alpha during the sample ptid, The regression ine i ls called the security characteristic ln. Optimal active polio constructed from the index model include analyzed securities in propor: tion to their information ratios. The fl risky portfolio is a mixture of the active portfolio and the passive market index portfolio, The index portfolio is used to enhance the diversification ofthe ‘yerall risk position. Practitioner routinely estimate the index model using tal rater than excess rats of return, This makes ther estimate of alpha equal toa + r(1 = Betas show a tendency to evolve towaed I ove time. eta forecasting rules atempt to predict this Avift Moreover, other Gnas variables eat be use to help forecast betas single-factor model residuals information ratio. single index model security characteristic line tracking portfolio regression equation scatter diagram 1, What are the advantages ofthe index model compared to the Markowitz procedure for obtaining an efficiently diversified portfolio? What ae its disadvantages? ‘What isthe basic trade-off when departing from pure indexing in favor ofan actively managed portfolio? How does the magnitude of firm-specific risk affect the extent to which an active investor will be willing to depat from an indexed portfolio? Why do we call alpha a “nonmarket” return premium’? Why are high-alpha stocks desirable investments for ative portfolio managers? With all other paraneters hed Fixed, what would hap- pen to a portfolio's Sharpe ratio asthe alpha of ts component securities increased? SUMMARY Related Web iter for ths chacer are avalable atwivnmhe.com/ ble KEY TERMS PROBLEM SETS Quiz & 2 E § 2 S 3 5S 3 Afollo Theory and Practice ‘A bonis angst oa les 60 oes and consucts earl en pomtolousing oly thas 60 seve, ‘a. Which stock has higher firm-specific risk? 2, Which stock has greater systematic (market) risk? (Which stook has higher R2? 4. Which stock has higher alpha? ‘6 Which stock has higher comelation withthe market? 8. Consider the two (excess return) index model regression results for A and B: R= 1% 4 1.2Ry Resquare = 576 Residual standard deviation = 10.39% Ry = 29+ Ry Resquare = 436 Residual standard deviation ~ 9.1%CHAPTER 8 Index Models Which stock has more firm-specific risk? ‘Which has greater market risk? . For which stock does market movement explain a greater fraction of rewrn vatlabilty? d, If 7, were constant at 6% and the regression had been run using total rather than excess Feturns, what would have been the regression intercept fr stock A? Use the following data for Problems 9 through 14. Suppose that the index modal for stocks A and B is estimated from excess returns with the following results: By = 3% +.7Ry +e, Ry =~ 240 + 1.2Ry + ey oy ~ 20%; Resquare, = 20; R-squarey = 12 ‘9, What isthe stundard deviation of each stock? 10, Break down the variance ofeach stock tothe systematic and firm-specific components. 11, What are the covariance and correlation coefficient between the two stocks? 12, Whats the covariance between each stock and the matket index? 13, For portfolio P with investment proportions of 60 in A and ,40 in, rework Problems 9,10, and 12. 14, Rework Problem 13 for portfolio @ with investment proportions of 50 in P, 30 in the market index, and 20 in Tis 15, A stock recently has been estimated to have a beta of 1.24: ‘a What will Merrill Lynch compote asthe “adjusted beta” ofthis stock? Suppose that you estimate the following regression desribing the evolution of beta ove time: B= 34 7B What would be your predicted beta for next year? 16, Based on current dividend yields and expected growth rte, the expected rates of return on stocks A and Bare 11% and 14%, respectively. The beta of stock Ais 8, while that of sock B is 15. The ‘Till rate is curently 6%, while the expected rate of return on the S&P 500 index is 12% The ‘Standard deviation of stock Ais 10% annually, while that of stock B is 11%, If you currently old 4 passive index portfolio, would you choose to add either ofthese stocks to your holdings? 17, A portfolio manager summarizes the inputfrom the macro and miero forecasters i the follow- ing table: Micro Forecasts ‘Asset Expected Return () Bota Residual Standard Daviation (0) Stock A 20 13 se Steck B 18 18 n Stock ¢ ” 07, 60 Stock D 2 10 55 Macro Forecasts Asset Expected Return (%) Till 8 Passive equity portfolio 16 4, Caleulate expected excess returns, alpha values, and residual variances for these stocks. . Construct the optimal risky portfolio What ig Sharpe's measure for the optimal portfolio and how much oF itis contributed by the active portfolio? <4. What should be the exact makeup ofthe complete portfolio for an investor with a coefficient of tsk aversion of 2.87Prblem 17 fora poling wos nwa sor sl eatin 8 Matt ote inn of har ee! : Pace 1 et : aaa se pio?” Suppose Watbased oye sara ah ‘he impression ofl forest? * ‘Suppose thatthe alpia forecasts dn tow 44 of Spreadsheet 6,1 are doubled. All Us tier -reinain the x Se ee la 9 SSeS ee ARS tire it of ni hie atthe entation 097 017 43,02%° 2145 ate sample period. Comment on their implications for future. risk-retura telation sont ee dl eerie ‘common stock portfolio, especially in view the following adltonal dita obained from two brokerage hovses, ‘on 2 years of weekly: ‘data ending in ‘Decegnber 2008. Grokerage House" Beta of ABC Bota of XYZ a 182, 4.85 @ oo 1.25 What percentage of Baker Fund’s total isk ib specific (ie, nonsystematic)? ‘The corielation between the Charioitesvlle Intemational Fund and the EAFE Market Index | is 1.0. The expected return on the EAFE Index ig 11%, the, expected return on Charlottesville ‘Intersational Fund is 9%, andthe risk-free rena in EAFE counties is 3%. Based on this analy- ‘si, what isthe implied beta of Charlottesville International? ‘The concept of haa is most closly associated with 4 Correlation coetficients ’. Meant-variance analysis. c. Nonsystematic risk 4. Systematic tisk ‘Beta and standard deviation differ as risk measures in that beta measures: ‘2. Only unsystematic risk, while standard deviation measures tot risk. 4. Only systematic risk, while standard deviation measures total risk.CHAPTER 8 Index Models 277| fe. Both systematic and unsystematic risk, while standard deviation measures only unsystems atic tisk, 1. Both systematic and unsystemati tsk, while standard deviation measures only systematic rit, 6b to wornsmhhe.convedumerketinsight and click on the Company link. Enter the.tcker syfbel forthe sick of your choice and click onthe Go button, nthe Excel Analyte se tion go to the Market Data section and get the Monthly Adjusted Prices data for the past Fajuats: Tho page vl alco show monthly rus for your stock ane for tho SAP 500, Copy Baits or = alyietitvay and vi es aromeeaeen aceanie te esac Bier the sock (se th mens for Tock Gata Arai, Regrossion inout He X ange ard tho Y range, sloct New Worksheet Ply under Output Options, and dk on OK) Based Bs Fegeesenr raul whet ste Bata coeftcen| Or your sooce? TANDA Newt use Excel to plot an XY Scatter graph of the stock’ retums versus the S&P 500s SROORS is Cred tacts cose! eet nec netea bore we rahr econ A Meese re 00 reine Son aye colea te Pine yes: On ve Options ib, elect By Caister at Chote Pow dove tie equusey carte diy ai ecresse aestal IGo beck to the isin page for jour stocks Information and select SBP Stock Reports I amie Create Sis hacer press ties ay dure recceererre pens Wife the botacceticient forthe fir, How does this beta compere to your results? What are Possible reasons for any differences? Bota Estimates Go to http://finance.yahoo.com and click on Stocks link under the investing tab. Look for the Stock Sereener link under Research Tools. The Java Yahoo! Finance Screener lets you create your ovin screens. In the Click to Add Criteria box, find Trading and Volume on the menu and choose Beta. In the Conditions box, choose <= and in the Values box, enter 1. Hit'the Enter key and then request the top 200 matches in the Return Top_Matches box. Click on the Run Screen button. ‘Select the View Table tab and sort the results to show the lowest betas at the top Cf the lst by clicking on the Beta column header. Which firms have the lowest betas? In which industries do they operate? Select the View Histogram tab and when the histogram appears, look at the bot- tom of the screen to see the Show Histogram for box. Use the menu that comes up when you click on the down arrow to select beta. What patterns), if any, do you see in the distributions of betas for firms that have betas less than 1? SOLUTIONS TO CONCEPT CHECKS 1. a Total market capitalization is 3,000 + 1,940 + 1,360 = 6.300, Therefore, the mean excess return ofthe index portfolio is 3,000 360 5200 x10+ 17 = 9.05% = 905 190 9 G é