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Tutorial 6

THE UNIVERSITY OF HONG KONG


Faculty of Business and Economics
FINA2802_FINA2320_D – Investments and Portfolio Analysis
1st SEMESTER, 2017-2018

Chapter 8 Index Models

 8.1 A Single-Factor Security Market


 The input list of Markowitz Model for a n risky securities portfolio:
n estimates of expected returns
n estimates of variances
𝑛2 − 𝑛
estimates of covariances
2
𝒏𝟐 − 𝒏
𝟐𝒏 + 𝒕𝒐𝒕𝒂𝒍 𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒔
𝟐

 Normality of Returns and Systematic Risk


ri = E(ri ) + Ui
 Ui has a mean of zero and a SD of σi

ri = E(ri ) + βi m + ei
 m is the uncertainty about the economy: it has a E(rm ) = 0 and σm
 βi measures the sensitivity of stock i to the macroeconomic factor
 ei is the uncertainty about the particular firm: it has a E(rei ) = 0 and σei
 m and ei are uncorrelated
σi = β2i σ2m + σ2ei
2

 m is correlated across securities.


 ei and ej are uncorrelated across securities
Cov(ri , rj ) = βi βj σ2m

 8.2 The Single-Index Model


 The regression equation of the Single-Index Model
𝐑 𝐢 = 𝛂𝐢 + 𝛃𝐢 𝐑 𝐌 + 𝐞𝐢
 R M = rm − rf is the market index excess return: it has a E(R M ) and σM
 R i = ri − rf is the security excess return: it has a E(R i ) and σi
 βi measures the sensitivity of stock i to the macroeconomic factor
 ei is the uncertainty about the particular firm: it has a E(rei ) = 0 and σei
 M and ei are uncorrelated
 M is correlated across securities.
 ei and ej are uncorrelated across securities
𝐄(𝐑 𝐢 ) = 𝛂𝐢 + 𝛃𝐢 𝐄(𝐑 𝐌 )

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Tutorial 6

𝛔𝟐𝐢 = 𝛃𝟐𝐢 𝛔𝟐𝐌 + 𝛔𝟐𝐞𝐢


𝐂𝐨𝐯(𝐫𝐢 , 𝐫𝐣 ) = 𝛃𝐢 𝛃𝐣 𝛔𝟐𝐌
𝛃𝐢 𝛃𝐣 𝛔𝟐𝐌
𝛒𝐢,𝐣 =
𝛔𝐢 𝛔𝐣

 The set of estimates needed for the Single-Index Model for n risky securities
n estimates of αi
n estimates of βi
n estimates of σ2ei
1 estimates of E(R M )
1 estimates of σ2M
𝟑𝒏 + 𝟐 𝒕𝒐𝒕𝒂𝒍 𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒔

 The Index Model and Diversification


𝐑 𝐏 = 𝛂𝐏 + 𝛃𝐏 𝐑 𝐌 + 𝐞𝐏
𝐧

𝛂𝐏 = ∑ 𝐰𝐢 𝛂𝐢
𝐢=𝟏
𝐧

𝛃𝐏 = ∑ 𝐰𝐢 𝛃𝐢
𝐢=𝟏
𝐧

𝐞𝐏 = ∑ 𝐰𝐢 𝐞𝐢
𝐢=𝟏

𝛔𝟐𝐏 = 𝛃𝟐𝐏 𝛔𝟐𝐌 + 𝛔𝟐𝐞𝐏

 8.3 Estimating the Single-Index Model

 The Security Characteristic Line

 Using simple regression, we can estimate  and .

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Tutorial 6

 Residual (ei) = Actual Ri – Predicted Ri


𝛃𝟐𝐢 𝛔𝟐𝐌 𝐄𝐱𝐩𝐥𝐚𝐢𝐧𝐞𝐝 𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 SS Regression
𝐑𝟐 = 𝟐 𝟐 = (From ANOVA table = )
𝛃𝐢 𝛔𝐌 + 𝛔𝟐𝐞𝐢 𝐓𝐨𝐭𝐚𝐥 𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 SS Total

 We are using the Market excess return to explain the security’s excess return, so only
systematic risk component can be explained by the factor – Market excess return.

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Tutorial 6

PROBLEM SET 1
A portfolio management organization analyzes 60 stocks and constructs a mean-variance
efficient portfolio using only these 60 securities.
a. How many estimates of expected returns, variances, and covariances are needed to
optimize this portfolio?

n = 60 estimates of means
n = 60 estimates of variances
𝐧𝟐 − 𝐧
= 𝟏𝟕𝟕𝟎 𝐞𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐬
𝟐
Therefore, in total
𝐧𝟐 + 𝟑𝐧
= 𝟏𝟖𝟗𝟎 𝐞𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐬
𝟐
:
b. If one could safely assume that stock market returns closely resemble a single-index
structure, how many estimates would be needed?

n = 60 estimates of the mean E(ri )


n = 60 estimates of the sensitivity coefficient β i
n = 60 estimates of the firm-specific variance σ2(ei )
1 estimate of the market mean E(rM )
1 estimate of the market variance 𝛔𝟐𝐌
Therefore, in total, 182 estimates.

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Tutorial 6

PROBLEM SET 2
The following are estimates for two stocks.
Stock Expected Return Beta Firm-Specific Standard Deviation
A 13% 0.8 30%
B 18 1.2 40
The market index has a standard deviations of 22% and the risk-free rate is 8%.
a. What are the standard deviations of stocks A and B?
σ2i = β2i σ2M + σ2ei
σA = √0.82 × 0.222 + 0.302 = 34.78%
σB = √1.22 × 0.222 + 0.402 = 47.93%

b. Suppose that we were to construct a portfolio with proportions:


Stock A: 0.30
Stock B: 0.45
T-bills: 0.25
Compute the expected return, beta, nonsystematic standard deviation, and standard
deviation of the portfolio.

E(rP ) = wA × E(rA ) + wB × E(rB ) + wf × rf


E(rP ) = (0.30 × 13%) + (0.45 × 18%) + (0.25 × 8%)
= 14%

βP = wA × βA + wB × βB + wf × β f
βP = (0.30 × 0.8) + (0.45 × 1.2) + (0.25 × 0.0)
= 0.78

σ2ep = wA2 × σ2eA + wB2 × σ2eB + wf2 × σ2ef


= (0.302 × 0.302 ) + (0.452 × 0.402 ) + (0.252 × 0)
= 0.0405
σep = √0.0405 = 𝟎. 𝟐𝟎𝟏𝟐

σ2p = β2p σ2M + σ2ep


= 0.782 0.222 + 0.20122
= 0.069928
σp = √0.069928 = 𝟎. 𝟐𝟔𝟒𝟒

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Tutorial 6

PROBLEM SET 3
Consider the following two regression lines for stocks A and B in the following figure.

a. Which stock has higher firm-specific risk?


The two figures depict the stocks’ security characteristic lines (SCL). Stock A has higher
firm-specific risk because the deviations of the observations from the SCL are larger for
Stock A than for Stock B. Deviations are measured by the vertical distance of each
observation from the SCL.

b. Which stock has greater systematic (market) risk?


Beta is the slope of the SCL, which is the measure of systematic risk. The SCL for Stock
B is steeper; hence Stock B’s systematic risk is greater.

c. Which stock has higher R2 ?


The R2 (or squared correlation coefficient) of the SCL is the ratio of the explained
variance of the stock’s return to total variance, and the total variance is the sum of the
explained variance plus the unexplained variance (the stock’s residual variance):

2
β2i σ2M Explained Variance
R = 2 2 =
βi σM + σ2ei Total Variance
Since the explained variance for Stock B is greater than for Stock A (the explained variance
isβ2p σ2M , which is greater since its beta is higher), and its residual variance σ2eB is smaller, its
R2 is higher than Stock A’s.

d. Which stock has higher alpha?


Alpha is the intercept of the SCL with the expected return axis. Stock A has a small
positive alpha whereas Stock B has a negative alpha; hence, Stock A’s alpha is larger.

e. Which stock has higher correlation with the market?


The correlation coefficient is simply the square root of R2, so Stock B’s correlation with
the market is higher.

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Tutorial 6

PROBLEM SET 4
Consider the two (excess return) index model regression results for A and B:

a. Which stock has more firm-specific risk?


Firm-specific risk is measured by the residual standard deviation. Thus, stock A has
more firm-specific risk: 10.3% > 9.1%

b. Which has greater market risk?


Market risk is measured by beta, the slope coefficient of the regression. A has a larger
beta coefficient: 1.2 > 0.8

c. For which stock does market movement explain a greater fraction of return variability?
R2 measures the fraction of total variance of return explained by the market return.
A’s R2 is larger than B’s: 0.576 > 0.436

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Tutorial 6

PROBLEM SET 5
Use the following data for sections a through f. Suppose that the index model for
stocks A and B is estimated from excess returns with the following results:

a. What is the standard deviation of each stock?


β2i σ2M
R2 = 2 2
βi σM + σ2ei

β2A σ2M
σ2A =
R2
2
0.72 × 0.22
σA =
0.20
σA = √0.0980 = 𝟎. 𝟑𝟏𝟑𝟏

β2B σ2M
σ2B =
R2
2
1.22 × 0.22
σB =
0.12
σB = √0.48 = 𝟎. 𝟔𝟗𝟐𝟖

b. Break down the variance of each stock to the systematic and firm-specific components.
β2A σ2M = 0.72 × 0.22 = 𝟎. 𝟎𝟏𝟗𝟔
σ2A = β2A σ2M + σ2eA
0.0980 = 0.0196 + σ2eA
σ2eA = 𝟎. 𝟎𝟕𝟖𝟒

β2B σ2M = 1.22 × 0.22 = 𝟎. 𝟎𝟓𝟕𝟔


σ2B = β2B σ2M + σ2eB
0.48 = 0.0576 + σ2eB
σ2eB = 𝟎. 𝟒𝟐𝟐𝟒

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Tutorial 6

c. What are the covariance and correlation coefficient between the two stocks?
Cov(rA , rB ) = βA βB σ2M
= 0.70 × 1.2 × 0.202
= 𝟎. 𝟎𝟑𝟑𝟔

βA βB σ2M
ρA,B =
σA σB
0.0336
=
0.3131 × 0.6928
= 𝟎. 𝟏𝟓𝟓

d. What is the covariance between each stock and the market index?
Cov(rA , rM ) = βA βM σ2M
= 0.70 × 1 × 0.202
= 𝟎. 𝟎𝟐𝟖

Cov(rB , rM ) = βB βM σ2M
= 1.2 × 1 × 0.202
= 𝟎. 𝟎𝟒𝟖

e. For portfolio P with investment proportions of 60% in A and 40% in B, what is the variance
related to the systematic and unsystematic components, the standard deviation of P and the
covariance of the portfolio P and the market index?
σ2p = β2p σ2M + σ2ep

βP = wA × βA + wB × βB
βP = (0.6 × 0.7) + (0.4 × 1.2)
= 0.90

σ2ep = wA2 × σ2eA + wB2 × σ2eB


= (0.62 × 0.0784) + (0.42 × 0.4224)
= 0.09581

β2p σ2M = 0.902 × 0.202 = 𝟎. 𝟎𝟑𝟐𝟒

σ2p = 0.09581 + 0.0324


σ2p = 0.1282
σp = √0.1282 = 𝟎. 𝟑𝟓𝟖𝟏

Cov(rP , rM ) = βP βM σ2M
= 0.90 × 1 × 0.202 = 𝟎. 𝟎𝟑𝟔

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Tutorial 6

Alternative way for covariance between P and M:


Cov(rP,rM )
= Cov(0.6rA + 0.4rB, rM )
= 0.6 × Cov(rA, rM ) + 0.4 × Cov(rB,rM )
= (0.6 × 0.028) + (0.4 × 0.048) = 0.036

f. Rework section e for portfolio Q with investment proportions of 50% in P, 30% in the
market index, and 20% in T-bills.

σ2Q = β2Q σ2M + σ2eQ

βQ = wP × βP + wM × βM + wf × βf
βQ = (0.5 × 0.9) + (0.3 × 1) + 0
= 0.75

σ2eQ = wP2 × σ2eP + wM


2
× σ2eM + wF2 × σ2eF
= (0.5 × 0.09581) + (0.32 × 0) + 0
2

= 0.02395

β2Q σ2M = 0.752 × 0.202 = 𝟎. 𝟎𝟐𝟐𝟓

σ2p = 0.0225 + 0.02395


σ2p = 0.04645
σp = √0.4645 = 𝟎. 𝟐𝟏𝟓𝟓

Cov(rQ , rM ) = βQ βM σ2M
= 0.75 × 1 × 0.202 = 𝟎. 𝟎𝟑𝟎

Tutorial 6
Tutorial 6

PROBLEM SET 6
Based on current dividend yields and expected growth rates, the expected rates of return on
stocks A and B are 11% and 14%, respectively. The beta of stock A is .8, while that of stock
B is 1.5. The T-bill rate is currently 6%, while the expected rate of return on the S&P 500
index is 12%. The standard deviation of stock A is 10% annually, while that of stock B is
11%. If you currently hold a passive index portfolio, would you choose to add either of
these stocks to your holdings?
αA = rA − [rf + βA × (rm − rf )]
αA = 11% − [6% + 0.8(12% − 6%)]
αA = 0.2%

αB = rB − [rf + βB × (rm − rf )]
αA = 14% − [6% + 1.5(12% − 6%)]
αA = −1%

Stock A would be a good addition to a well-diversified portfolio. A short position in


Stock B may be desirable.

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Tutorial 6

PROBLEM SET 7
When the annualized monthly percentage rates of return for a stock market index were
regressed against the returns for ABC and XYZ stocks over a 5-year period ending in 2008,
using an ordinary least squares regression, the following results were obtained:

Explain what these regression results tell the analyst about risk–return relationships for each
stock over the sample period. Comment on their implications for future risk–return
relationships, assuming both stocks were included in a diversified common stock portfolio,
especially in view of the following additional data obtained from two brokerage houses,
which are based on 2 years of weekly data ending in December 2008.

The regression results provide quantitative measures of return and risk based on
monthly returns over the five-year period.
β for ABC was 0.60, considerably less than the average stock’s β of 1.0. This indicates
that, when the S&P 500 rose or fell by 1 percentage point, ABC’s return on average
rose or fell by only 0.60 percentage point. Therefore, ABC’s systematic risk (or market
risk) was low relative to the typical value for stocks. ABC’s alpha (the intercept of the
regression) was –3.2%, indicating that when the market return was 0%, the average
return on ABC was –3.2%. ABC’s unsystematic risk (or residual risk), as measured by
σ(e), was 13.02%. For ABC, R2 was 0.35, indicating closeness of fit to the linear
regression greater than the value for a typical stock.
β for XYZ was somewhat higher, at 0.97, indicating XYZ’s return pattern was very
similar to the β for the market index. Therefore, XYZ stock had average systematic
risk for the period examined. Alpha for XYZ was positive and quite large, indicating a
return of 7.3%, on average, for XYZ independent of market return. Residual risk was
21.45%, half again as much as ABC’s, indicating a wider scatter of observations
around the regression line for XYZ. Correspondingly, the fit of the regression model
was considerably less than that of ABC, consistent with an R2 of only 0.17.
The effects of including one or the other of these stocks in a diversified portfolio may
be quite different. If it can be assumed that both stocks’ betas will remain stable over
time, then there is a large difference in systematic risk level. The betas obtained from
the two brokerage houses may help the analyst draw inferences for the future. The
three estimates of ABC’s β are similar, regardless of the sample period of the
underlying data. The range of these estimates is 0.60 to 0.71, well below the market
average β of 1.0. The three estimates of XYZ’s β vary significantly among the three
sources, ranging as high as 1.45 for the weekly data over the most recent two years.

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Tutorial 6

One could infer that XYZ’s β for the future might be well above 1.0, meaning it might
have somewhat greater systematic risk than was implied by the monthly regression for
the five-year period.
These stocks appear to have significantly different systematic risk characteristics. If these
stocks are added to a diversified portfolio, XYZ will add more to total volatility.

Tutorial 6
Tutorial 6

PROBLEM SET 8
Assume the correlation coefficient between Baker Fund and the S&P 500 Stock Index is .70.
What percentage of Baker Fund’s total risk is specific (i.e., nonsystematic)?
The R2 of the regression is: 0.702 = 0.49
Therefore, 51% of total variance is unexplained by the market; this is
nonsystematic risk.

Tutorial 6