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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
Tutorial 6
Tutorial 6
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
𝛂𝐏 = ∑ 𝐰𝐢 𝛂𝐢
𝐢=𝟏
𝐧
𝛃𝐏 = ∑ 𝐰𝐢 𝛃𝐢
𝐢=𝟏
𝐧
𝐞𝐏 = ∑ 𝐰𝐢 𝐞𝐢
𝐢=𝟏
Tutorial 6
Tutorial 6
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.
Tutorial 6
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?
Tutorial 6
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%
βP = wA × βA + wB × βB + wf × β f
βP = (0.30 × 0.8) + (0.45 × 1.2) + (0.25 × 0.0)
= 0.78
Tutorial 6
Tutorial 6
PROBLEM SET 3
Consider the following two regression lines for stocks A and B in the following figure.
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.
Tutorial 6
Tutorial 6
PROBLEM SET 4
Consider the two (excess return) index model regression results for A and B:
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
Tutorial 6
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:
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
Tutorial 6
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
Cov(rP , rM ) = βP βM σ2M
= 0.90 × 1 × 0.202 = 𝟎. 𝟎𝟑𝟔
Tutorial 6
Tutorial 6
f. Rework section e for portfolio Q with investment proportions of 50% in P, 30% in the
market index, and 20% in T-bills.
βQ = wP × βP + wM × βM + wf × βf
βQ = (0.5 × 0.9) + (0.3 × 1) + 0
= 0.75
= 0.02395
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%
Tutorial 6
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.
Tutorial 6
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