Econ 424/Amath 540

Single Index Model

Eric Zivot
August 9, 2012
Sharpes Single Index Model
1
it
= c
i
+o
i
1
At
+.
it
i = 1, . . . , .; t = 1, . . . , T
where
c
i
, o
i
are constant over time
1
At
= return on diversied market index portfolio
.
it
= random error term unrelated to 1
At
Assumptions
cov(1
At
, .
ic
) = 0 for all t, c
cov(.
ic
, .
)t
) = 0 for all i 6= ), t and c
.
it
iid .(0, o
2
.,i
)
1
A,t
iid .(j
A
, o
2
A
)
Interpretation of .
it
:
.
it
= 1
it
c
i
o
i
1
At
Return on market index, 1
At
, captures common market-wide news.
o
i
measures sensitivity to market-wide news
Random error term .
it
captures rm specic news unrelated to market-
wide news.
Returns are correlated only through their exposures to common market-
wide news captured by o
i
.
Remark:
The CER model is a special case of Single Index (SI) Model where o
i
= 0 for
all i = 1, . . . , ..
1
it
= c
i
+.
it
In this case, c
i
= 1[1
i
] = j
i
Statistical Properties of the SI Model (Unconditional)
j
i
= 1[1
it
] = c
i
+o
i
j
A
o
2
i
= var(1
it
) = o
2
i
o
2
A
+o
2
.,i
o
i)
= cov(1
it
, 1
)t
) = o
2
A
o
i
o
)
1
it
.(j
i
, o
2
i
) = .(c
i
+o
i
j
A
, o
2
i
o
2
A
+o
2
.,i
)
Derivations:
var(1
it
) = var(c
i
+o
i
1
At
+.
it
)
= o
2
i
var(1
At
) + var(.
it
)
= o
2
i
o
2
A
+o
2
.,i
where
o
2
i
o
2
A
= variance due to market news
o
2
.,i
= variance due to non-market news
Next
o
i)
= cov(1
it
, 1
)t
)
= cov(c
i
+o
i
1
At
+.
it
, c
)
+o
)
1
At
+.
)t
)
= cov(o
i
1
At
, o
)
1
At
) + cov(o
i
1
At
, .
)t
)
+ cov(o
)
1
At
, .
it
) + cov(.
it
, .
)t
)
= o
i
o
)
cov(1
At
, 1
At
)
= o
2
A
o
i
o
)
Implications:
o
i)
= 0 if o
i
= 0 or o
)
= 0 (asset i or asset j do not respond to market
news)
o
i)
0 if o
i
, o
)
0 or o
i
, o
)
< 0 (asset i and j respond to market news
in the same direction)
o
i)
< 0 if o
i
0 and o
)
< 0 or if o
i
< 0 and o
)
0 (asset i and j
respond to market news in opposite direction)
Statistical Properties of the SI Model (Conditional on 1
At
)
Given that we observe, 1
At
= v
At
1[1
it
|1
At
= v
At
] = c
i
+o
i
v
At
o
2
i
= var(1
it
|1
At
= v
At
) = o
2
.,i
o
i)
= cov(1
it
, 1
)t
|1
At
= v
At
) = 0
1
it
|1
At
= v
At
.(c
i
+o
i
v
At
, o
2
.,i
)
Interpretation of o
i
o
i
=
cov(1
it
, 1
At
)
var(1
At
)
=
o
iA
o
2
A
o
i
captures the contribution of asset i to the variance/risk of the market index.
Derivation:
cov(1
it
, 1
At
) = cov(c
i
+o
i
1
At
+.
it
, 1
At
)
= cov(o
i
1
At
, 1
At
) + cov(.
it
, 1
At
)
= o
i
var(1
At
)
o
i
=
cov(1
it
, 1
At
)
var(1
At
)
Decomposition of Total Variance
o
2
i
= var(1
it
) = o
2
i
o
2
A
+o
2
.,i
total variance = market variance + non-market variance
Divide both sides by o
2
i
1 =
o
2
i
o
2
A
o
2
i
+
o
2
.,i
o
2
i
= 1
2
i
+ 1 1
2
i
where
1
2
i
=
o
2
i
o
2
A
o
2
i
= proportion of market variance
1 1
2
i
= proportion of non-market variance
Sharpes Rule of Thumb: A typical stock has 1
2
i
= 30%; i.e., proportion of
market variance in typical stock is 30% of total variance.
Return Covariance Matrix
3 asset example
1
it
= c
i
+o
i
1
At
+.
it
, i = 1, 2, 3
o
2
i
= var(1
it
) = o
2
i
o
2
A
+o
2
.,i
o
i)
= cov(1
it
, 1
)t
) = o
2
A
o
i
o
)
Covariance matrix
=

o
2
1
o
12
o
13
o
12
o
2
2
o
23
o
13
o
23
o
2
3

o
2
1
o
2
A
+o
2
.,1
o
2
A
o
1
o
2
o
2
A
o
1
o
3
o
2
A
o
1
o
2
o
2
2
o
2
A
+o
2
.,2
o
2
A
o
2
o
3
o
2
A
o
1
o
3
o
2
A
o
2
o
3
o
2
3
o
2
A
+o
2
.,3

= o
2
A

o
2
1
o
1
o
2
o
1
o
3
o
1
o
2
o
2
2
o
2
o
3
o
1
o
3
o
2
o
3
o
2
3

o
2
.,1
0 0
0 o
2
.,2
0
0 0 o
2
.,3

Simplication using matrix algebra

o =

o
1
o
2
o
3

, D =

o
2
.,1
0 0
0 o
2
.,2
0
0 0 o
2
.,3

Then

(33)
= o
2
A
o
(31)
o
(13)
0
+ D
(33)
where
o
2
A
oo
0
= covariance due to market
D = asset specic variances
SI Model and Portfolios
2 asset example
1
1t
= c
1
+o
1
1
At
+.
1t
1
2t
= c
2
+o
2
1
At
+.
2t
a
1
= share invested in asset 1
a
2
= share invested in asset 2
a
1
+a
2
= 1
Portfolio return
1
j,t
= a
1
1
1t
+a
2
1
2t
= a
1
(c
1
+o
1
1
At
+.
1t
)
+a
2
(c
2
+o
2
1
At
+.
2t
)
= (a
1
c
1
+a
2
c
2
) + (a
1
o
1
+a
2
o
2
) 1
At
+ (a
1
.
1t
+a
2
.
2t
)
= c
j
+o
j
1
At
+.
j,t
where
c
j
= a
1
c
1
+a
2
c
2
o
j
= a
1
o
1
+a
2
o
2
.
j,t
= a
1
.
1t
+a
2
.
2t
SI Model with Large Portfolios
i = 1, . . . , . assets (e.g. . = 500)
a
i
=
1
.
= equal investment shares
1
it
= c
i
+o
i
1
At
+.
it
Portfolio return
1
j,t
=
.
X
i=1
a
i
1
it
=
.
X
i=1
a
i
(c
i
+o
i
1
At
+.
it
)
=
.
X
i=1
a
i
c
i
+

.
X
i=1
a
i
o
i

1
At
+
.
X
i=1
a
i
.
it
=
1
.
.
X
i=1
c
i
+

1
.
.
X
i=1
o
i

1
At
+
1
.
.
X
i=1
.
it
= c +

o1
At
+ .
t
where
c =
1
.
.
X
i=1
c
i

o =
1
.
.
X
i=1
o
i
.
t
=
1
.
.
X
i=1
.
it
Result: For large .,
.
t
=
1
.
.
X
i=1
.
it
1[.
it
] = 0
because .
it
iid .(0, o
2
.,i
).
Implications
In a large well diversied portfolio, the following results hold:
1
j,t
c +

o1
At
: all non-market variance is diversied away
var(1
j,t
) =

o
2
var(1
At
) : Magnitude of portfolio variance is propor-
tional to market variance. Magnitude of portfolio variance is determined
by portfolio beta

o
1
2
j
1 : Approximately 100% of portfolio variance is due to market
variance