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Advantage of the Single Index Model stems from its simplifying assumptions
Computational Advantages
The single-index model compares securities to a single benchmark all
An alternative to comparing a security to each of the others By observing how two independent securities behave relative to a third value, we learn something about how the securities are likely to behave relative to each other
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Ri ! E i F i RM ei
R P ! EP FPR M eP
Individual asset
Portfolio
Beta
A security s beta is
% % COV ( Ri , Rm ) Fi ! 2 Wm % where R ! return on the market index
m 2 m
xi F i
i !1
As the number of assets in portfolio increases, the second term becomes less and less 8 important
Multi-Index Model
A multi-index model considers independent variables other than the performance of an overall market index
Of particular interest are industry effects
Factors associated with a particular line of business
Multi-Index Model
The general form of a multi-index model:
% % % % % Ri ! ai F im I m F i1 I1 F i 2 I 2 ... F in I n where ai ! constant % I m ! return on the market index % I ! return on an industry index
j
F ij ! Security i's beta for industry index j F im ! Security i's market beta % Ri ! return on Security i
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E(W
2 port
) ! w W w W 2w 1 w 2 r1,2W 1W 2
2 1
2 1
2 2
2 2
Substituting the risk-free asset for Security 1, and the risky asset for Security 2, this formula would become
2 2 E(W port ) ! w 2 W RF (1 w RF ) 2 W i2 2w RF (1 - w RF )rRF,iW RF W i RF
Since we know that the variance of the risk-free asset is zero and the correlation between the risk-free asset and any risky asset i is zero we can adjust the formula
E(W
2 port
) ! (1 w RF ) W
2 i
E(W port ) ! (1 w RF ) 2 W i2
! (1 w RF ) W i
Therefore, the standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio.
12%
8%
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
A risktaker
12%
8%
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
12%
8%
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier
E(R port )
RFR
E(W port )
Fund Separation
Everyone s U-maximizing portfolio consists of a combination of 2 assets only: Risk-free asset and the market portfolio. This is true irrespective of the difference of their risk-preferences
E(Rp)
B E(RM)
CML
M]
(Rp)
Rf
M
(Rp)
Graph of SML
R(R i )
SML
Rm
Negative Beta
RFR
1.0
Beta(Cov im/W 2 )
M
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Nonstationary Beta Problem: Difficulty tied to the fact that betas are inherently unstable
Other Problems:
(1926-2004) US Market
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Small Stocks
Looking at that plot, small stocks appear to have higher returns. Do these stocks correctly plot on the SML?
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The risk premium related to this factor is 1 percent for every 1 percent change in the rate
(P1 ! .01)
= percent growth in real GNP. The average risk premium 2 related to this factor is 2 percent for every 1 percent change in the rate
(P2 ! .02)
(P3 ! .03)
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