CHAPTER EIGHT
INDEX MODELS
CHAPTER EIGHT
INDEX MODELS
CHAPTER OVERVIEW
The single-factor index model is introduced; this model predicts stock returns based upon both the firm
specific and market risks of the security. Using the single-factor model allows the risk to be decomposed
into systematic and unsystematic components and reduces the number of inputs required to diversify in
an efficient manner. The chapter addresses practical issues that arise when implementing the index
model.
LEARNING OBJECTIVES
Upon completion of this chapter the student should have a full understanding of systematic and firm-
specific risk, and of how one can reduce the amount of firm-specific risk in the portfolio by combining
securities with differing patterns of returns. Furthermore, if the portfolio is adequately diversified and
firm-specific (or nonsystematic) risk is virtually eliminated, then beta (or systematic risk) becomes the
relevant risk measure for the portfolio. The student should be able to identify inputs required to use the
index model and understand the characteristic line.
PRESENTATION OF MATERIAL
8.1 A Single-Factor Security Market
The advantages of the single factor or single index model over the Markowitz model are presented here.
One of the advantages of the single factor model is the reduction in data that is needed for portfolio
analysis. With just 50 securities, the traditional diversification approach requires over 1300 estimates.
8.2 The Single-Index Model
The single-factor model is developed in this first section. Basic properties associated with diversification
and the single index model are presented. As n gets large the error term becomes negligible and the risk
remaining the portfolio is systematic.
8.3 Estimating the Single-Index Model
Estimating the single index model is demonstrated in detail using Hewlett-Packard. Complete regression
analysis and a plot of the characteristic line are presented. A sample regression output is displayed in
Table 8.1 and excess returns are presented in Figure 8.2.
8.4 Portfolio Construction and the Single-Index Model
This section presents alpha and security analysis along with the single-index model input list. The text
develops the concept of the information ratio and describes how to optimally weight the actively
managed portfolio with the passive or index portfolio.
8-1
CHAPTER EIGHT
INDEX MODELS
Table 8.2 displays the differences for the selected securities for both the minimum variance portfolios and
the optimal portfolios. Using the single-index model and the full-covariance approach are compared. It is
suggested that instructors walk students through the Summary of Optimization Procedure.
8.5 Practical Aspects of Portfolio Management with the Index Model
Consideration of the differences between the industry version of the single-index model and the single
index model developed in the text are covered in this final section. The industry version that is presented
does not use a risk premium format so the estimate of alpha is not consistent with the version developed
in the text. Further betas are adjusted for tendency of beta to regress toward a mean of 1.0 over time.
8-2
