Sharp’es Single Index Model

RAVI
 Introduction - MPT
• The modern portfolio theory was developed in early 1950s by Nobel
Prize Winner Harry Markowitz in which he made a simple premise that
almost all investors invest in multiple securities rather than in a single
security, to get the benefits from investing in a portfolio consisting of
different securities.
• In this theory, he tried to show that the variance of the rates of return
is a meaningful measure of portfolio risk under a reasonable set of
assumptions and also derived a formula for computing the variance of a
portfolio. His work emphasizes the importance of diversification of
investments to reduce the risk of a portfolio and also shows how to
diversify such risk effectively.
 Limitations of MPT
• One of the most significant limitations of Markowitz’s model is the
increased complexity of computation that the model faces as the
number of securities in the portfolio grows. To determine the variance
of the portfolio, the covariance between each possible pair of
securities must be computed, which is represented in a covariance
matrix.
• If there are n securities in a portfolio, the Markowitz’s model requires
n average (or expected) returns, n variance terms
• To this direction, in 1963 William F. Sharpe had developed a simplified
Single Index Model (SIM) for portfolio analysis taking cue from
Markowitz’s concept of index for generating covariance terms.
• Sharpe’s Single Index Model is very useful to construct an optimal
portfolio by analyzing how and why securities are included in an
optimal portfolio, with their respective weights calculated on the
basis of some important variables under consideration.
 Assumptions of Single Index Model
• The Sharpe’s Single Index Model is based on the following
assumptions:
• All investors have homogeneous expectations.
• A uniform holding period is used in estimating risk and return for each
security.
• The price movements of a security in relation to another do not
depend primarily upon the nature of those two securities alone. They
could reflect a greater influence that might have cropped up as a
result of general business and economic conditions.
Assumptions of Single Index Model
• The relation between securities occurs only through their individual
influences along with some indices of business and economic
activities.
• The indices, to which the returns of each security are correlated, are
likely to be some securities’ market proxy.
• The random disturbance terms e(i) has an expected value zero (0) and
a finite variance. It is not correlated with the return on market
portfolio (Rm) as well as with the error term (ei) for any other
securities.
Single Index Model Graphical illustration
Single index model
Stock prices are related to the market index and this relationship could be
used to estimate the return of stock.
Ri = ai + bi Rm + ei
where Ri — expected return on security i
ai — intercept of the straight line or alpha co-efficient
bi — slope of straight line or beta co-efficient
Rm — the rate of return on market index
ei — error term
 Single Index Model formula
• To simplify analysis, the single-index model assumes that there is only 1
macroeconomic factor that causes the systematic risk affecting all stock
returns and this factor can be represented by the rate of return on a market
index, such as the S&P 500.
• According to this model, the return of any stock can be decomposed into the
expected excess return of the individual stock due to firm-specific factors,
commonly denoted by its alpha coefficient (α), which is the return that
exceeds the risk-free rate, the return due to macroeconomic events that
affect the market, and the unexpected microeconomic events that affect only
the firm. Specifically, the return of stock i is:
ri = αi + βirm + ei
• The term βirm represents the stock's return due to the movement of the
market modified by the stock's beta (βi), while ei represents the
unsystematic risk of the security due to firm-specific factors.
• Macroeconomic events, such as interest rates or the cost of labor, causes
the systematic risk that affects the returns of all stocks,
• and the firm-specific events are the unexpected microeconomic events that
affect the returns of specific firms, such as the death of key people or the
lowering of the firm's credit rating, that would affect the firm, but would
have a negligible effect on the economy.
• The unsystematic risk due to firm-specific factors of a portfolio can be
reduced to zero by diversification.
• The variance of the security has two components – Systematic and
Unsystematic risk (Unique Risk)
• The variance explained by the Index is referred as Systematic Risk
• The unexplained variance is called residual or unsystematic risk
• To simplify analysis, the single-index model assumes that there is only
1 macroeconomic factor that causes the systematic risk affecting all
stock returns and this factor can be represented by the rate of return
on a market index, such as the S&P 500.
• According to this model, the return of any stock can be decomposed
into the expected excess return of the individual stock due to firm-
specific factors, commonly denoted by its alpha coefficient (α), which
is the return that exceeds the risk-free rate, the return due to
macroeconomic events that affect the market, and the unexpected
microeconomic events that affect only the firm. Specifically, the
return of stock i is:
• ri = αi + βirm + ei
• The term βirm represents the stock's return due to the movement of
the market modified by the stock's beta (βi), while ei represents the
unsystematic risk of the security due to firm-specific factors.
• Macroeconomic events, such as interest rates or the cost of labor,
causes the systematic risk that affects the returns of all stocks, and
the firm-specific events are the unexpected
• microeconomic events that affect the returns of specific firms, such as the
death of key people or the lowering of the firm's credit rating, that would
affect the firm, but would have a negligible effect on the economy. The
unsystematic risk due to firm-specific factors of a portfolio can be reduced to
zero by diversification.
• The index model is based on the following:
• Most stocks have a positive covariance because they all respond similarly to
macroeconomic factors.
• However, some firms are more sensitive to these factors than others, and
this firm-specific variance is typically denoted by its beta (β), which measures
its variance compared to the market for one or more economic factors.
• Covariances among securities result from differing responses to macroeconomic
factors. Hence, the covariance (σ2) of each stock can be found by multiplying their
betas by the market variance:
• Cov(Ri, Rk) = βiβkσ2.
• This last equation greatly reduces the computations, since it eliminates the need
to calculate the covariance of the securities within a portfolio using historical
returns and the covariance of each possible pair of securities in the portfolio.
• With this equation, only the betas of the individual securities and the market
variance need to be estimated to calculate covariance.
• Hence, the index model greatly reduces the number of calculations that would
otherwise have to be made for a large portfolio of thousands of securities.
• Security Characteristic Line
• The comparison of a stock's excess return can be plotted against the
market's excess return on a scatter diagram using linear regression to
construct a line that best represents the data points. This regression
line, called the security characteristic line (SCL), is a graph of both the
systematic and the unsystematic risk of a security. The intercept of
the regression line is the alpha of the security while the slope of the
line is equal to its beta.