Sharpes Single Index

Model
RAVI

Introduction - MPT
The modern portfolio theory was developed in early 1950s by
Nobel Prize Winner Harry Markowitz in which he made a simple
premise that almost all investors invest in multiple securities
rather than in a single security, to get the benefits from
investing in a portfolio consisting of different securities.
In this theory, he tried to show that the variance of the rates of
return is a meaningful measure of portfolio risk under a
reasonable set of assumptions and also derived a formula for
computing the variance of a portfolio. His work emphasizes the
importance of diversification of investments to reduce the risk
of a portfolio and also shows how to diversify such risk
effectively.

Limitations of MPT
One of the most significant limitations of Markowitzs
model is the increased complexity of computation that
the model faces as the number of securities in the
portfolio grows. To determine the variance of the
portfolio, the covariance between each possible pair of
securities must be computed, which is represented in a
covariance matrix.
If there are n securities in a portfolio, the Markowitzs
model requires n average (or expected) returns, n
variance terms

 To this direction, in 1963 William F. Sharpe had

developed a simplified Single Index Model (SIM) for
portfolio analysis taking cue from Markowitzs concept
of index for generating covariance terms.
Sharpes Single Index Model is very useful to construct
an optimal portfolio by analyzing how and why
securities are included in an optimal portfolio, with their
respective weights calculated on the basis of some
important variables under consideration.

Assumptions of Single Index

Model
The Sharpes Single Index Model is based on the
following assumptions:
All investors have homogeneous expectations.
A uniform holding period is used in estimating risk and
return for each security.
The price movements of a security in relation to another
do not depend primarily upon the nature of those two
securities alone. They could reflect a greater influence
that might have cropped up as a result of general
business and economic conditions.

Assumptions of Single Index Model

The relation between securities occurs only through
their individual influences along with some indices of
business and economic activities.
The indices, to which the returns of each security are
correlated, are likely to be some securities market
proxy.
The random disturbance terms e(i) has an expected
value zero (0) and a finite variance. It is not correlated
with the return on market portfolio (Rm) as well as with
the error term (ei) for any other securities.

Single Index Model Graphical

illustration

Single index model

Stock prices are related to the market index and this
relationship could be used to estimate the return of stock.
Ri = i + i Rm + ei
where Ri expected return on security i
i intercept of the straight line or alpha co-efficient
i slope of straight line or beta co-efficient
Rm the rate of return on market index
ei error term

Single Index Model formula

To simplify analysis, the single-index model assumes that there is
only 1 macroeconomic factor that causes the systematic risk
affecting all stock returns and this factor can be represented by the
rate of return on a market index, such as the S&P 500.
According to this model, the return of any stock can be decomposed
into the expected excess return of the individual stock due to firmspecific factors, commonly denoted by its alpha coefficient (),
which is the return that exceeds the risk-free rate, the return due to
macroeconomic events that affect the market, and the unexpected
microeconomic events that affect only the firm. Specifically, the
return of stock i is:

ri = i + irm + ei

 The term irm represents the stock's return due to the movement of
the market modified by the stock's beta (i), while ei represents the
unsystematic risk of the security due to firm-specific factors.
Macroeconomic events, such as interest rates or the cost of labor,
causes the systematic risk that affects the returns of all stocks,
and the firm-specific events are the unexpected microeconomic
events that affect the returns of specific firms, such as the death of
key people or the lowering of the firm's credit rating, that would
affect the firm, but would have a negligible effect on the economy.
The unsystematic risk due to firm-specific factors of a portfolio can be
reduced to zero by diversification.

 The variance of the security has two components

Systematic and Unsystematic risk (Unique Risk)
The variance explained by the Index is referred as
Systematic Risk
The unexplained variance is called residual or
unsystematic risk

 To simplify analysis, the single-index model assumes

that there is only 1 macroeconomic factor that causes
the systematic risk affecting all stock returns and this
factor can be represented by the rate of return on a
market index, such as the S&P 500.

 According to this model, the return of any stock can be

decomposed into the expected excess return of the
individual stock due to firm-specific factors, commonly
denoted by its alpha coefficient (), which is the return
that exceeds the risk-free rate, the return due to
macroeconomic events that affect the market, and the
unexpected microeconomic events that affect only the
firm. Specifically, the return of stock i is:
ri = i + irm + ei

 The term irm represents the stock's return due to the

movement of the market modified by the stock's beta
(i), while ei represents the unsystematic risk of the
security due to firm-specific factors.
Macroeconomic events, such as interest rates or the
cost of labor, causes the systematic risk that affects the
returns of all stocks, and the firm-specific events are
the unexpected

 microeconomic events that affect the returns of specific firms,

such as the death of key people or the lowering of the firm's credit
rating, that would affect the firm, but would have a negligible
effect on the economy. The unsystematic risk due to firm-specific
factors of a portfolio can be reduced to zero by diversification.
The index model is based on the following:
Most stocks have a positive covariance because they all respond
similarly to macroeconomic factors.
However, some firms are more sensitive to these factors than
others, and this firm-specific variance is typically denoted by its
beta (), which measures its variance compared to the market for
one or more economic factors.

 Covariances among securities result from differing responses to

macroeconomic factors. Hence, the covariance ( 2) of each stock can be
found by multiplying their betas by the market variance:
Cov(Ri, Rk) = ik2.
This last equation greatly reduces the computations, since it
eliminates the need to calculate the covariance of the securities
within a portfolio using historical returns and the covariance of
each possible pair of securities in the portfolio.
With this equation, only the betas of the individual securities and the
market variance need to be estimated to calculate covariance.
Hence, the index model greatly reduces the number of calculations that
would otherwise have to be made for a large portfolio of thousands of
securities.

 Security Characteristic Line

The comparison of a stock's excess return can be
plotted against the market's excess return on a scatter
diagram using linear regression to construct a line that
best represents the data points. This regression line,
called the security characteristic line (SCL), is a
graph of both the systematic and the unsystematic risk
of a security. The intercept of the regression line is the
alpha of the security while the slope of the line is equal
to its beta.