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Single Index Model

The Sharpe Single Index Model describes how an individual stock's return can be broken down into three components: (1) the market return, (2) the stock's sensitivity to the market (beta), and (3) an error term. It is used to model how a stock's price changes in relation to the overall stock market. The model can also be applied to portfolios, where the portfolio's return, risk, and beta are calculated as weighted averages of the individual holdings. The document provides examples of using the model to decompose stock returns and calculate a portfolio's expected return and risk.

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Neelam Madarapu
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31 views

Single Index Model

The Sharpe Single Index Model describes how an individual stock's return can be broken down into three components: (1) the market return, (2) the stock's sensitivity to the market (beta), and (3) an error term. It is used to model how a stock's price changes in relation to the overall stock market. The model can also be applied to portfolios, where the portfolio's return, risk, and beta are calculated as weighted averages of the individual holdings. The document provides examples of using the model to decompose stock returns and calculate a portfolio's expected return and risk.

Uploaded by

Neelam Madarapu
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Single Index Model

10/11/2021
3:10-4:25

Sharpe Single Index Model:


 The equation of Sharpe Single Index Model is r
. =
𝛼 , +𝛽, 𝑟 , +𝜀, .
 It is understood that when the overall stock market

represented by any broad based stock index goes up,


most stock prices also usually increase and when the
market declines, stock prices also decline.
 It indicates that the stock returns are correlated with

market returns due to common response to the


market.
 In the equation, error term (𝜀 ) has mean return of
,
zero and its correlation with market returns (𝑅 ) is
zero.
 Hence, correlation between error terms of two

securities (𝜀 , and 𝜀 , ) is also zero.


 Mean return of security (i) is 𝑅 = 𝛼 + 𝛽 𝑅

 Variance of security (i) is 𝜎 = 𝛽 𝜎 +𝜎


 Thus, variance has two components, market related

risk (𝛽 𝜎 ) and unique risk (𝜎 ).


 Covariance of returns between securities (i) and (j) is

σ =𝛽𝛽𝜎 .
 As the securities are related with each other due to

common response to the market, covariance depends


on market risk.
Illustration:
Consider the following data of stock-A and decompose its
returns assuming α is 0.6 and its beta is 1.5.

Period Stock return (𝑅 ) Market Return (𝑅 )


1 10.00 6.00
2 5.00 4.00
3 17.00 10.00
4 11.00 8.00
5 5.00 2.00

Solution:
e = 𝑅 − (0.6 + 1.5𝑅 )

As per Single Index Model, the returns can be decomposed


as follows:

Period Stock Market α +β 𝑅 +𝜀 𝑅


return Return
(𝑅 ) (𝑅 )
1 10.00 6.00 0.60 9.00 0.40 10.00
2 5.00 4.00 0.60 6.00 -1.60 5.00
3 17.00 10.00 0.60 15.00 1.40 17.00
4 11.00 8.00 0.60 12.00 -1.60 11.00
5 5.00 2.00 0.60 3.00 1.40 5.00
Total 48.00 30.00 3.00 45.00 0.00 48.00
Average 9.60 6.00 0.60 9.00 0.00 9.60
Variance 19.84 8.00 0.00 18.00 1.84 19.84
Mean return of stock-A:
𝑅 =𝛼 +𝛽𝑅
𝑅 = 0.6 + (1.5 ∗ 6) = 9.60%

Variance of stock-A:
𝜎 =𝛽 𝜎 +𝜎
σ = (1.5^2*8)+1.84=19.84%

Practice Problem:
Consider the following data of stock-B and decompose its
returns assuming α is 0.38 and its beta is 1.27.

Period Stock return (𝑅 ) Market Return (𝑅 )


1 10.00 6.00
2 3.00 4.00
3 15.00 10.00
4 9.00 8.00
5 3.00 2.00

Solution:

𝑒 = 𝑅 − (0.38 + 1.27𝑅 )
As per Single Index Model, the returns can be decomposed
as follows:

Period Stock Market α +β 𝑅 +𝜀 𝑅


return Return
(𝑅 ) (𝑅 )
1 10.00 6.00 0.38 7.62 2.00 10.00
2 3.00 4.00 0.38 5.08 - 3.00
2.46
3 15.00 10.00 0.38 12.70 1.92 15.00
4 9.00 8.00 0.38 10.16 - 9.00
1.54
5 3.00 2.00 0.38 2.54 0.08 3.00
Total 40.00 30.00 1.90 38.10 0.00 40.00
Average 8.00 6.00 0.38 7.62 0.00 8.00
Variance 20.80 8.00 0.00 12.90 3.22 16.12

Mean return of stock-B:


𝑅 =𝛼 +𝛽𝑅
𝑅 = 0.38 + (1.27 ∗ 6) = 8%

Variance of stock-B:
σ =β σ +σ
σ = (1.27^2*8)+3.22=16.12%
Covariance:
Variance of Nifty returns is 110% . If beta of ABC stock is
0.7 and beta of XYZ stock is 1.1, covariance between the
stock of ABC and that of XYZ is
Solution:
Covariance of returns between securities (i) and (j) is
σ =𝛽𝛽𝜎
Covariance between returns of ABC and XYZ =
0.7*1.1*110=84.7% .

Single Index Model for Portfolios


 Alpha (𝛼 ) and beta of portfolio (𝛽 ) is weighted

average of alphas (𝛼 ) and betas (𝛽 ) of individual


securities in the portfolios, where weights are
proportions of investment in each security.

𝛼 = 𝑋𝛼

𝛽 = 𝑋𝛽

 Hence, return of portfolio is 𝑅 = 𝛼 + 𝛽 𝑅


 Variance of portfolio is σ = 𝛽 𝜎 + ∑ 𝑋 𝜎
 In case of an equally weighted portfolio, when the
number of stocks (N) increases, the importance of
average residual risk ∑ decreases.
 Hence, portfolio risk gets reduced to σ = 𝛽 𝜎
 It indicates that diversifiable risk (𝜎 ) can be eliminated
when large portfolio is held.

Illustration:
Consider a portfolio consisting 40% of stock-A and 60% of
stock-B and calculate the portfolio risk and return. The
market returns are 6% with a variance of 8(%) .
𝛼 𝛽 𝜎
Stock-A 0.60 1.50 1.84
Stock-B 0.38 1.27 3.22

Solution:

𝛼 = 𝑋𝛼

𝛼 = (0.4*0.60)+(0.6*0.38)=0.468

𝛽 = 𝑋𝛽

𝛽 = (0.4*1.50)+(0.6*1.27)=1.362
Portfolio Return
𝑅 =𝛼 +𝛽 𝑅

𝑅 = 0.468+(1.362*6)=8.64%

Portfolio Variance:

σ = 𝛽 𝜎 + 𝑋 𝜎

σ = (1.362^2*8)+2.668=17.5084(%)

Where
∑ 𝑋 𝜎 =(0.4*1.84)+(0.6*3.22)=2.668

Portfolio Standard Deviation:

𝜎 = sqrt(17.5084)=4.1843%

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