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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 i i RM ei
RP P PRM eP
Beta
A securitys beta is
COV ( Ri , Rm )
2 sm
Ri return on Security i
p xi i
i 1
s
2 p
2 m
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 im I m i1 I1 i 2 I 2 ... in I n where ai constant I m return on the market index I j return on an industry index
ij Security i's beta for industry index j im Security i's market beta
Ri return on Security i
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E(s
2 port
) w s w s 2w 1 w 2 r1,2s 1s 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(s port ) w 2 s RF (1 w RF ) 2 s i2 2w RF (1 - w RF )rRF,is RFs 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(s
2 port
) (1 w RF ) s
2
2 i
E(s port ) (1 w RF ) 2 s i2
(1 w RF ) s 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(s port )
Fund Separation
Everyones 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
A
Rf M
(Rp)
Graph of SML
R(R i )
SML
Rm
Negative Beta
RFR
1.0
Beta(Cov im/ s 2 )
M
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Nonstationary Beta Problem: Difficulty tied to the fact that betas are inherently unstable
firm size
low P/E, price/cash flow, P/B, and sales growth
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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42
(1 .01) (2 .02)
= 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
(3 .03)
SMB = small minus big = rsmall rbig HML = high B/M minus low B/M = rvalue rgrowth
F&F does a better job alpha very close to zero Main criticism: No theory justifying why size and B/M should be risk factors.
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