C h a p t e r Three_Lecture 08

Market Model

Dr. Md. Monimul Haque

Professor
Dept. of Finance, R.U.
C h a p t e r Three

Market Model

Chapter Learning Objectives

 Reduces the number of inputs for diversification
 Easier for security analysts to specialize
 Describe how the single index model can be used to simplify
portfolio analysis
 Market Model
Concern with the computational burden in
deriving the Markowitz portfolio theory,
William Sharpe (1963) developed a theory to
describe the relationship between the
market index return and a particular
security’s return which is known as Market
Model.

This model tells that there is a linear

relationship exists between a security’s
return and market index. That is if the
market index goes up then it is likely that a
particular security’s price goes up and vice-
 Market Model
We have learned that investors should diversify.
Individual securities will be held in a portfolio.
Consequently, the relevant risk of an individual
security is the risk that remains when the security is
placed in a portfolio.
What do we call the risk that cannot be diversified
away, i.e., the risk that remains when the stock is
put into a portfolio? Systematic risk
How do we measure a stock’s systematic risk?
Systematic risk arises from events that affect the
entire economy, such as a change in interest rates
or GDP or a financial crisis such as occurred in 2007
and 2008.
 Market Model
If a well diversified portfolio has no unsystematic
risk then any risk that remains must be systematic.
That is, the variation in returns of a well diversified
portfolio must be due to changes in systematic
factors.
How do we measure a share’s systematic risk?
Systematic factors
 Returns Δ interest rates,
Returns well Δ GDP,
share A diversified Δ consumer spending,
portfolio etc.
 Market Model
Single factor model
R i E Ri  i R m  ei
R i  Actual excess return = ri – rf
E(Ri) = expected excess return

Two sources of Uncertainty

M = some systematic factor or proxy; in this case M
is unanticipated movement in a well diversified
broad market index like the S&P ASX 200
βi = sensitivity of a securities’ particular return to
the factor
ei = unanticipated firm specific events
 Market Model
Single index model parameter estimation
ri  rf i  i rm  rf  ei
Risk premium Market risk premium or index risk
premium
αi
= the stock’s expected excess return if the market’s
excess return is zero, i.e. (rm – rf) = 0
βi ( rm – rf) = the component of excess return due
to movements in the market index
ei = firm specific component of excess return that is
not due to market movements
Estimating the index model

Scatter
Excess returns
plot
(i)

. .. . . .. . . .
. .
Security
characteristic
line

. .. . .. .
. .
. .
. . . Excess returns

. .. ..
. .
. . . ..
on market index
R .= a + ß R + e
. . . . . Slope of SCL = beta
i i i m i

.. . . . . y-intercept = alpha
 Market Model
When a portfolio manager considers a security for
addition to a portfolio within the construct of
mean variance analysis, he/she must determine
what return for the x-variable represents “market
portfolio”.

The Market Model assumes that some security

market index, such as the S&P 500, represents the
market portfolio. In our capital market DSE 30,
represents the market portfolio.
Market Model Equation:
The Market Model is a single variable regression
model, where alpha return is the constant and beta is
the security’s return coefficient on the independent (x)
variable of the market index’s.

The market model allows for a security’s expected

return to be priced by linear regression.
R it  it  i R mt  eit
Where α and β = Regression parameter or estimated
constant of the model
Rit= return on security i in period t
Rmt = return on the market portfolio in t
period
eit = random or standard error
Market Model Equation:
The assumption of the model;
 Expected value of the eit is zero, i.e., E(eit) = 0
 No correlation between Rmt and eit, if they are
independent.
 The βi term in the above market model is the beta
or relative risk of a security or market risk
Using these assumptions, the procedure for mean-
variance analysis becomes very simple.
 Market Model Equation:
In sum, the index model separates the realized rate of
return on a security into macro (systematic) and micro
(firm-specific) components. The excess rate of return on
each security is the sum of three components:
 Market Model Equation:
Because the firm-specific component of the stock return
is uncorrelated with the market return, we can write the
variance of the excess return of the stock as

Therefore, the total variance of the rate of return of each security is

a sum of two components:
1. The variance attributable to the uncertainty of the entire
market. This variance depends on both the variance of RM, Ϭ2M
and the beta of the stock on RM .
2. The variance of the firm-specific return, e i , which is
independent of market performance.
 Market Model Equation:
Because the firm-specific component of the stock return
is uncorrelated with the market return, we can write the
variance of the excess return of the stock as

Single Asset .3025 = .2050+.0950 Return =

15%
= 67.75% +32.25%

Portfolio .2325 = .2050+ .025

Return = 15%
= 89.25% + 10.75%
= 99% + 1%
Example:
Consider stock A, which has αit = 2% and βi =
1.2. This means that the market model for
stock A is
Rit = 2% + 1.2 Rmt + eit
If Rmt = 10%, Rit would be (2% + 12%)
= 14%
If Rmt = -5%, Rit would be (2% - 6%) = -
4%
Portfolio Return and Total Risk:
Given the market model in the above assumptions,
the expected return and variance of equally
weightedEportfolio
( R p ) become –
p   p (R m )  e p
σ2(Rp)= β2p σ2(Rm) + σ2(ep)

Where,
σ2(Rp) = Total Variance
β2p σ2(Rm) = Systematic Variance
N
σ (e
2
1) = Unsystematic Variance
P p   P
2
N
i 1
N
P  1 N 
i 1
P
Portfolio Return and Total Risk:
The second term on the right hand side of the above equation
σ2(e2p) relatively is less important or insignificant as N increases.

In a large well-diversified portfolio, the β 2p σ2(Rm) component is

the major contributor to σ2(Rp). This result is of fundamental
importance in the portfolio theory.

Total risk of a portfolio measured by the variance of the

portfolio’s returns and denoted by σ2(Rp) will be
σ2(Rp) = β2pσ 2(Rm) + σ2 (ep)

where, β2p = [1/N∑ βi ]2

σ2 (ep) = [1/N∑ σ2 ei]
Portfolio Return and Total Risk:
The above equation shows that the total risk of any portfolio can be viewed
as having two components similar to the two components of the total risk of
an individual security. These two components are known as market risk β 2p
σ2(Rm) and the unique risk (idiosyncratic risk) σ 2(ep).

As the number of securities in the portfolio increases, diversification

increases leading to the reduction of a portfolio’s total risk. The unique risk is
reduced due to increase in the size of the portfolio.
 Reduces the number of inputs needed to account for diversification
benefits.
If you want to know the risk of a 25 stock portfolio you would have to
calculate 25 variances and (25 x 24) = 600 covariance terms
With the index model you need only 25 betas.
 Easy reference point for understanding stock risk.
βM = 1, so if βi > 1 what do we know?
If β < 1?
Portfolio Return and Total Risk:

Total risk = Systematic +

Unsystematic
Examining Percentage of Variance
Systematic Risk/Total Risk = 2
ßi2  m2 / 2 = 2
i2 m2 / i2 m2 + 2(ei) = 2
Risk Reduction with Diversification
Well-diversified portfolio:
Diversification is therefore, can substantially
reduce the unique risk. Generally, a portfolio
containing equal proportion of 30 or more
randomly selected securities in its will have a
relatively small amount of unique risk. It’s total
risk will be slightly greater than the amount of
market risk and such portfolio called a well-
diversified portfolio
Example: Two Securities Portfolio
Consider two securities, A and B. these two securities have beta
values 1.2 and 0.8 respectively. The standard deviation of their
random error terms are 6.06% and 4.76% respectively and σ (Rm)
is 8%.
Given that, σ(eA) = 6.06%, σ2 (eA) = (6.06)2 = 37
σ (eB) = 4.76%, σ2 (eB) = (4.76)2 = 23
σ (Rm) = 8%, so σ2(Rm) = 82= 64
σ2(RA) = β2A σ2(Rm) + σ2 (eA)
= (1.2)2*64 + 37 = 129
σ2(RB) = β2B σ2(Rm) + σ2 (eB)
= (0.8)2*64 + 23 = 64
Example: Two Securities Portfolio
Combining securities A and B into a portfolio, with an equal
amount of the investors’ money going into each security, that is
WA = 0.5 and WB = 0.5. Since βA = 1.2 and βB = 0.8, the beta of the
portfolio can be calculated using the following equation;
β p = W A βA + W B βB
= (0.5)(1.2) + (0.5)(0.8) = 1.0
σ2 (ep) = (0.5)2(37) + (0.5)2(23) = 15
Now, σ2(Rp) = β2p σ2(Rm) + σ2 (ep)
= (1.0)2(64) +15 = 79, this represents the
total risk of the two security portfolio

Since, 79 > 64 but slightly greater than the marker risk, fulfils the
condition of a well-diversified portfolio. A well-diversified
portfolio reduces the total risk of the portfolio substantially
Example: Three Securities Portfolio
Considering the third security C into the above portfolio where
weights are equal i.e., WA = WB = WC =0.33 and σ (eC) = 5.50%,
so, σ2(eC) = (5.5)2 = 30, and βC = 1.0.
σ2(RC) = β2C σ2(Rm) + σ2 (eC)
= 12*64 + 30 = 94
βp = (.33*1.2) + (.33 *0.8) + (.33*1.0) = 1.0
σ2 (ep) = (0.33)2(37) + (0.33)2(23) + (0.33)2(30) = 10
Hence, σ2 (ep for 3security portfolio ) < σ2 (ep for 2 security portfolio)
That is 10 < 15, unique risk decreases.
σ2(Rp) = β2p σ2(Rm) + σ2 (ep)
= (1.02*64) + 10 = 74
74 < 79
As N increases, total risk of the portfolio reduces.
Example: Problems
Example: Solution
Let the correlation between security A and B is +1, then
the SD of the portfolio would be
σ2(Rp) = W2Aσ2A+ W2Bσ2B+2. WA WB.rAB. σAσB
= (.35)2(20)2+(.65)2(25)2+2*.35*.65*1*20*25 =
541
σ (Rp) = √541 = 23.26%
Again, Let the correlation between security A and B is -1,
then the SD of the portfolio would be
σ 2(Rp) = WA σ 2A+ WB σ 2B+2. WA WB.rAB. σAσB
= (.35)2(20)2+(.65)2(25)2+2*.35*.65*-
1*20*25
= 85
σ (Rp) = √85 = 9.22%
Maximum SD is 23.26% and Minimum SD is 9.22% that
may be produced.
Example: Problem
Example: Solution
We know the total risk of the portfolio is
σ2(Rp) = β2p σ2(Rm) + σ2 (ep)
= 1.134*(.18)2 + 18.41
= 385.89
σ (Rp) = √385.89 = 19.67% this is the
total risk of
Saggy’s portfolio.

Working 1: β2p = {(.30*1.2) + (.50*1.05) +

(.20*0.90)} = 1.134
Working 2: σ2 (ep) = (.302*52)+ (.502*82)+ (.202*22) =
18.41
 Factor Model: Introduction
 Factor models or index models assume that the
return on a security is sensitive to the
movements of different factors, or indices.
 The market model assumes only one factor i.e.,
the return on a market index.
 In attempting to accurately estimate expected
returns, variances, and co-variances for
securities, multiple factor models are
potentially more useful than movements in a
market index.
 Factor Model: Introduction
 A factor model attempts to capture the major
economic forces that systematically move the prices
of all securities.

 It is assumed that the returns on two securities are

correlated – that is, will move together – only
through common reactions to one or more factors
specified in the model.

 Any aspect of a security’s return unexplained by the

factor model is assumed to be unique or specific to
the security and uncorrelated with the unique
elements of returns on other securities. A factor
 Factor Model: One Factor Model
Some investors argue that the return-
generating process for securities involves a
single factor. For example, the returns on
securities respond to the growth rate in the GDP
Factor Model Data
Year GDP Growth Rate Inflation rate Return on stock X
1 5.7% 1.1% 14.3%
2 6.4% 2.1% 19.3%
3 7.9% 4.4% 23.4%
4 7.0% 4.6% 15.6%
5 5.1 6.1% 9.2%
6 2.9% 3.1% 13.0%
Factor Model: One Factor Model
 Factor Model: One Factor Model
 On the horizontal axis of the above figure is
GDP growth rate; the vertical axis measures
the return on stock X.
 Each point on the graph represents the
combination of X’s return and GDP growth
rate for a particular year.
 A line has been statistically fitted to the data
by using a technique known as simple linear
regression analysis (simple refers to the fact
that there is one variable).
 This line has positive slope of 2, indicating
that there exists a positive relationship
between GDP growth rates and X’s returns.
 Factor Model: One Factor Model
The relationship can be expressed as
rXt = aXt + bXGDPt + eXt

In the above figure, we find the zero factor is

4% per period. This is the return that would
be expected for X if GDP growth equaled
zero. The sensitivity of stock X to predicted
GDP growth rate is 2. This value indicates
that higher growth in GDP is associated
with higher return for stock X. If GDP
growth rate equaled 5%, stock X should
generate a return of 14% -
rXt = 4% + 2*5% + 0 = 14%
 Factor Model: One Factor Model
This example of a one factor model can be
generalized in equation form for any security i in
period t;
r it = ait + biFt + eit
where, Ft is the value of factor in period t, bi is the
sensitivity of security i to this factor

The expected return on security I can be written as

follows:
r = ai+ biF
where, F denotes the expected value of the
factor.
The variance of any security i with one-factor model
is equal to
σ2i = b2iσ2F+ σ2ei
 Factor Model: Multiple Factor Mo
Two-Factor Model: Consider a two-factor model which
assumes that the return-generating process contains
two factors. In equation form, the two-factor model for
period t is:
rit= ai+bi1F1t+bi2F2t+ eiit

For example, rt= ai+b1GDPt+b2INFt

The expected return for any security i can be

determined by specifying the expected value for the
two factors in the following formula:
rit= ai+bi1F1+bi2F2

According to the two-factor model, the variance for any security i

Factor Model: Example
On the basis of a one-factor model, security
A has a sensitivity of -.50, whereas security
B has a sensitivity of 1.25. If the covariance
between the two securities is -312.50, what
is the standard deviation of the factor?

We know the covariance between two

securities A and B is
σAB= bAbBσ2F
So, the variance of the factor
σ2F= σAB /bAbB = -312.50/-0.50*1.25 =
500,
σF = √500 = 22.36
Factor Model: Example
On the basis of a one-factor model, security
A has a sensitivity of -.50, whereas security
B has a sensitivity of 1.25. If the covariance
between the two securities is -312.50, what
is the standard deviation of the factor?

We know the covariance between two

securities A and B is
σAB= bAbBσ2F
So, the variance of the factor
σ2F= σAB /bAbB = -312.50/-0.50*1.25 =
500,
σF = √500 = 22.36
Factor Model: Example
On the basis of a one-factor model for two securities
A and B
r At = 5% + 0.80Ft + eAt = 9% when F= 5%
r Bt = 7% + 1.20Ft + eBt = 13%
σF = 18%, σeA = 25%, σeB = 15%
Calculate the standard deviation of each security.

Solution
In a one-factor model, the variance of any security i
equals
σ2i = b2iσ2F+ σ2ei

For A, σ2A = (.82 * 182 ) + 252 = 832.36, σA = 28.85%

For B, σ2B = (1.22 * 182 ) + 152 = 691.56, σB = 26.30%

Factor Model: Example

On the basis of a one-factor model, consider

a portfolio of two securities with the following
characteristics:
Security Factor Nonfactor Proportion
sensitivity
A .20 49 .40
B 3.50 100 .60
If the standard deviation of the factor is 15%,
i. What is the factor risk of the portfolio?
ii. What is the nonfactor risk of the portfolio?
iii. What is the portfolio’s standard deviation?
Factor Model: Example

Solution
i) Factor risk of the portfolio:
bp= ∑xibip = (.2 X .4) + (3.5 X .6) = 2.18

Factor risk b2pσ2F = (2.18)2 X (15)2

σ2p = 1069.31

ii) Nonfactor risk of the portfolio:

σ2ep = ∑xiep = σ2ei = (.42 X 49) + (.62 X 100) =
43.84

iii) Portfolio standard deviation:

σ2p = √(b2pσ2F+ σ2ep )= √(1069.31 + 43.84) = 33.36