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Markowitz Model

The document discusses the single index model, which is an empirical version of the capital asset pricing model (CAPM). It assumes that a broad stock market index is the single common factor influencing returns of all securities. The model expresses the expected return of an individual security as the sum of the risk-free rate, the security's sensitivity to the market (beta) multiplied by the excess market return, and an error term. It allows decomposing total risk into systematic and diversifiable risk and simplifying the inputs needed for portfolio optimization models. The document also discusses estimating the single index model via regression analysis and using it for security analysis and market neutral strategies.

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gulto
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754 views

Markowitz Model

The document discusses the single index model, which is an empirical version of the capital asset pricing model (CAPM). It assumes that a broad stock market index is the single common factor influencing returns of all securities. The model expresses the expected return of an individual security as the sum of the risk-free rate, the security's sensitivity to the market (beta) multiplied by the excess market return, and an error term. It allows decomposing total risk into systematic and diversifiable risk and simplifying the inputs needed for portfolio optimization models. The document also discusses estimating the single index model via regression analysis and using it for security analysis and market neutral strategies.

Uploaded by

gulto
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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A.

Single Index Model


The CAPM is a theory about expected
returns
The application of the CAPM, i.e., the
empirical version, is ex-post, or after the
fact
The empirical version is often referred to
as the Single Index Model
One step removed from the theoretical
CAPM and all of its assumptions
Single Index Model
A broad stock market index is assumed to
be the single, common factor for all
securities
(ri − rf ) = α i + β i (rm − rf ) + ei

α i = expected return of stock i if market’s excess


return is zero
β i(rmt - rft ) = component of return due to market
movements
eit = component of return due to unexpected firm-
Single Index Model
Textbook notation:
Ri = ri – rf and Rm = rm - rf
Therefore,

Ri = α i + β i Rm + ei
Early Application
To simplify the Markowitz model
Inputs of the Markowitz model: means,
standard deviations, and covariances (or
correlation coefficients) of the assets
If you have 50 assets in the investment
universe – how many covariances?
n(n-1) ÷ 2
1225
Simplifying the Markowitz
Model
Adopting the Single Index Model is a way to reduce this
number
– By simplifying the covariance
According to the model,
– All asset returns derive only from the common factor, RM
– ei is firm-specific, and hence uncorrelated across assets
Therefore,
Cov(Ri, Rj) = Cov(β iRM, β jRM ) = β iβ jσ 2
M
Implication for Security Analysis
This setup allows security analysts to
specialize
Provides rationale for why analysts do not
have to research other industries
Model says there is no relationship, only the
common factor (the market) matters
Decomposing Total Risk
Single Index Model for a portfolio of stocks:

R p = α p + β p Rm + e p
The variance of Rp is:

σ 2 = β 2σ 2 + σ 2 (e )
As the number of stocks
p
increases, the last term becomes less
p m p
important as a result of diversification
Total risk = systematic risk + diversifiable risk
If Portfolios are equally
weighted...

Pink curve: total risk. Can exclude proof on


pp.276-7
Estimating the Single Index
Model
Regression analysis

Rit = α i + β i Rmt + eit


Typically, use monthly returns over the past 5
years (i.e., 60 observations) to estimate β
Y: excess return on individual security (or
individual portfolio)
X: excess return on market index
Intercept is α i, slope is β i
Security Characteristic Line
Interpreting the Results

alpha
beta statistical significance
The Meaning of R2
The goodness-of-fit measure, R2, from
the Single Index Model regression
(the SCL) is: β 2σ 2 σ 2 (e )
R2 = i m
= 1− i
σ i2 σ i2

In words, the R2 = the percentage of


total risk of asset i that can be
explained by its systematic risk
Industry Versions
BMO Nesbitt Burns, Merrill Lynch, Value
Line
These (and several other) beta estimate
providers use raw returns, not excess
returns
That model is called the Market Model
Some firms forecast beta as a function of
past betas
Some firms forecast beta as a function of
firm size, growth, leverage,… etc.
Industry Versions
Merrill Lynch
‘Adjusted β ’: 2/3 sample beta and 1/3 beta of
one
Adjusted β = 2/3β + 1/3
Tendency for β to move toward one over time
Hence, take this into account in forecasts
Beta books
Merrill Lynch: monthly
Ibbotson Associates: semi-annual
Market Neutral Strategies
An application of the Single Index Model
Consider the following “market neutral”
investment strategy
Suppose the returns to the manager’s portfolio can
be characterized by (example on p.288):

You like theR p = 0.04


alpha, but+do
1.4not + e pthe market
RTSXwant
exposure
Market Neutral Strategies
First, create the following tracking portfolio, T:
1.4 RTSX
T is a leveraged portfolio:
1.4 in the TSX, and -0.4 in risk-free asset (or
use derivative securities)
(Typo in text: share in risk-free asset should be
-0.4, not 20.4)
Buy P and sell T. End result:

Rc = R p − RT = 0.04 + e p

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