Single Index Model

Eric Zivot

November 30, 2009

1 Beta as a Measure of Portfolio Risk

Key points:

• Asset specific risk can be diversified away by forming portfolios. What

remains is “portfolio risk”.

• Riskiness of an asset should be judged in a portfolio context

Motivating Example

Consider investing in an equally weighted portfolio with 99 assets

1
xi = , R99 = portfolio return, σ 299 = var(R99)
99
Now consider adding a new asset, say IBM, to the portfolio

RIBM = return on IBM, σ 2IBM = var(RIBM ),

σ 99,IBM = cov(R99, RIBM )
Create a new equally weighted portfolio of 100 assets

R100 = (.99)R99 + (.01)RIBM

Portfolio variance (risk)

var(R100) = (.99)2var(R99) + (.01)2var(RIBM ) +

2(.99)(.01)cov(R99, RIBM )
= (.98)σ 299 + (.0001)σ 2IBM + (.02)σ 99,IBM
≈ (.98)σ 299 + (.02)σ 99,IBM
3 Cases

1. Adding IBM does not change the risk of portfolio

σ 2100 = σ 299

2. Adding IBM increases portfolio risk

σ 2100 > σ 299

3. Adding IBM decreases portfolio risk

σ 2100 < σ 299

Case 1

If σ 2100 = σ 299 then

(.98)σ 299 + (.02)σ 99,IBM = σ 299
⇒ (.02)σ 99,IBM = (.02)σ 299
σ 99,IBM
⇒ =1
σ 299
cov(R99, RIBM )
⇒ =1
var(R99)
⇒ β IBM,99 = 1
Conclusion: if
cov(R99, RIBM )
β IBM,99 = =1
var(R99)
then adding IBM to the portfolio does not change risk (variance) of the port-
folio.
Case 2

If σ 2100 > σ 299 then

β IBM,99 > 1
and adding IBM to the portfolio increases the risk (variance) of the portfolio.

Case 3

If σ 2100 < σ 299 then

β IBM,99 < 1
and adding IBM to the portfolio decreases the risk (variance) of the portfolio.
Conclusion: beta measures portfolio risk

Rp = return on any portfolio

Ri = return on any asset i
cov(Ri, Rp) σ i,p
β i,p = = 2
var(Rp) σp
Conjecture: If β i,p is the appropriate measure of the risk of an asset, then the
asset’s expected return, μi, should depend on β i,p. That is

E[Ri] = μi = f (β i,p)
The Capital Asset Pricing Model (CAPM) formalizes this conjecture.
2 Sharpe’s Single Index Model

Rit = αi + β iRMt + εit

i = 1, . . . , N ; t = 1, . . . , T
where
αi, β i are constant over time
RMt = return on diversified market index portfolio
εit = random error term
Assumptions
cov(RMt, εis) = 0 for all t, s
cov(εis, εjt) = 0 for all i 6= j, t and s
εit ∼ iid N (0, σ 2ε,i)
RM,t ∼ iid N (μM , σ 2M )
Intuition:
εit = Rit − αi − β iRMt

• Return on market index, RMt, captures common “market-wide” news.

• β i measures sensitivity to “market-wide” news

• Random error term εit captures “firm specific” news unrelated to market-
wide news.

• Returns are correlated only through their exposures to common “market-

wide” news captured by β i.
Remark: CER model is a special case of Single Index (SI) Model where β i = 0
for all i = 1, . . . , N. In this case, αi = E[Ri] = μi
2.1 Statistical Properties of the SI Model

• μi = E[Rit] = αi + β iμM

• σ 2i = var(Rit) = β 2i σ 2M + σ 2ε,i

• σ ij = cov(Rit, Rjt) = σ 2M β iβ j
Derivations:

var(Rit) = var(αi + β iRMt + εit)

= β 2i var(RMt) + var(εit)
= β 2i σ 2M + σ 2ε,i
where

β 2i σ 2M = variance due to market news

σ 2ε,i = variance due to non-market news
Next

σ ij = cov(Rit, Rjt)
= cov(αi + β iRMt + εit, αj + β j RMt + εjt)
= cov(β iRMt, β j RMt) + cov(β iRMt, εjt)
+cov(β j RMt, εit) + cov(εit, εjt)
= β iβ j cov(RMt, RMt)
= σ 2M β iβ j
Implications:

• σ ij = 0 if β i = 0 or β j = 0 (asset i or asset j do not respond to market

news)

• σ ij > 0 if β i, β j > 0 or β i, β j < 0 (asset i and j respond to market news

in the same direction)

• σ ij < 0 if β i > 0 and β j < 0 or if β i < 0 and β j > 0 (asset i and j

respond to market news in opposite direction)
2.1.1 Interpretation of β i

cov(Rit, RMt) σ iM
βi = = 2
var(RMt) σM
β i captures the contribution of asset i to the variance/risk of the market index.

Derivation:

cov(Rit, RMt) = cov(αi + β iRMt + εit, RMt)

= cov(β iRMt, RMt)
= β ivar(RMt)
cov(Rit, RMt)
⇒ βi =
var(RMt)
2.1.2 Decomposition of Total Risk

σ 2i = var(Rit) = β 2i σ 2M + σ 2ε,i
total risk = market risk + non-market risk
Divide both sides by σ 2i

β 2i σ 2M σ 2ε,i
1 = 2 + 2
σi σi
= Ri2 + 1 − Ri2
where
β 2σ 2
Ri2 = i 2M = proportion of market risk
σi
1 − Ri2 = proportion of non-market risk
Sharpe’s Rule of Thumb: A typical stock has R2 = 30%; i.e., proportion of
market risk in typical stock is 30% of total risk.
2.1.3 Return Covariance Matrix

3 asset example

Rit = αi + β iRMt + εit, i = 1, 2, 3

σ 2i = var(Rit) = β 2i σ 2M + σ 2ε,i
σ ij = cov(Rit, Rjt) = σ 2M β iβ j
Covariance matrix
⎛ ⎞
2
σ 1 σ 12 σ 13
⎜ ⎟
Σ = ⎝ σ 12 σ 22 σ 23 ⎠
σ 13 σ 23 σ 23
⎛ ⎞
2 2
β σ + σ ε,1 2 2
σ M β 1β 2 2
σ M β 1β 3
⎜ 1 2M 2 2 2 2 ⎟
⎜
= ⎝ σ M β 1β 2 β 2σ M + σ ε,2 σ M β 2β 3 ⎟⎠
2
σ M β 1β 3 2
σ M β 2β 3 2 2 2
β 3σ M + σ ε,3
⎛ ⎞ ⎛ 2 ⎞
2
β 1 β 1β 2 β 1β 3 σ ε,1 0 0
⎜ ⎟ ⎜ ⎟
= σ 2M ⎝ β 1β 2 β 22 β 2β 3 ⎠ + ⎜ ⎝ 0 σ 2
ε,2 0 ⎟
⎠
β 1β 3 β 2β 3 β 23 0 0 σ 2ε,3
Simplification using matrix algebra
⎛ ⎞ ⎛ ⎞
β1 σ 2ε,1 0 0
⎜ ⎟
β=⎜ ⎟
⎝ β2 ⎠ , D =⎜
⎝ 0 σ 2
ε,2 0 ⎟
⎠
β3 0 0 σ 2ε,3
Then
Σ = σ 2M · β β 0+ D
(3×3) (3×1)(1×3) (3×3)

where

σ 2M · ββ 0 = covariance due to market

D = asset specific variances
2.2 SI Model and Portfolios

2 asset example

R1t = α1 + β 1RMt + ε1t

R2t = α2 + β 2RMt + ε2t
x1 = share invested in asset 1
x2 = share invested in asset 2
x1 + x2 = 1
Portfolio return

Rp,t = x1R1t + x2R2t

= x1(α1 + β 1RMt + ε1t)
+x2(α2 + β 2RMt + ε2t)
= (x1α1 + x2α2) + (x1β 1 + x2β 2) RMt
+ (x1ε1t + x2ε2t)
= αp + β pRMt + εp,t
where

αp = x1α1 + x2α2
β p = x1β 1 + x2β 2
εp,t = x1ε1t + x2ε2t
2.2.1 SI Model with Large Portfolios

i = 1, . . . , N assets (e.g. N = 500)

1
xi = = equal investment shares
N
Rit = αi + β iRMt + εit
Portfolio return
N
X
Rp,t = xiRit
i=1
XN
= xi (αi + β iRMt + εit)
i=1 ⎛ ⎞
XN N
X N
X
= xiαi + ⎝ xiβ i⎠ RMt + xiεit
i=1 i=1 i=1
⎛ ⎞
1 XN XN XN
1 1
= αi + ⎝ β i⎠ RMt + εit
N i=1 N i=1 N i=1
= ᾱ + β̄RMt + ε̄t
where
1 XN
ᾱ = αi
N i=1
1 XN
β̄ = β
N i=1 i
N
1 X
ε̄t = εit
N i=1

Result: For large N,

1 XN
ε̄t = εit ≈ 0
N i=1
because εit ∼ iid N (0, σ 2ε,i).
Implications

In a large well diversified portfolio, the following results hold:

• Rp,t ≈ ᾱ + β̄RMt : all non-market risk is diversified away

2
• var(Rp,t) = β̄ var(RMt) : Magnitude of portfolio risk is proportional to
market risk. Magnitude of portfolio risk is determined by portfolio beta β̄

• Rp2 ≈ 1 : Approximately 100% of portfolio risk is due to market risk