Topic 4: Index Models and Ethics Flashcards

1
Q

Why is the Markowitz portfolio selection model not very useful if 50 stocks are used?

A
  • Requiring a huge number of estimates of covariances
  • Due to mutual inconsistency, errors exist in the estimation of correlation coefficients, leading to nonsensical results (i.e. negative variances)
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2
Q

What are two assumptions made when using the single factor model?

A
  • We assume one macroeconomic indicator moves the security market as a whole
  • We also assume all remaining uncertainty in stock returns is firm-specific
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3
Q

When does it become the single factor model?

A
  • When we use a broad market index like S&P 500 as the common factor
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4
Q

firm specific terms are assumed to be what?

A
  • Assumed to be uncorrelated with the market and with each other
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5
Q

What is the only source of covariance in the returns?

A
  • So only source of covariance in the returns between the two stocks derives from their common dependence on the common factor
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6
Q

What estimates are needed for the single index model?

A
  • N estimates of expected excess returns
  • N estimates of the sensitivity coefficients
  • N estimates of the firm-specific variances
  • 1 estimate of the variance of the common macroeconomic factor
  • For a 50-security portfolio we only need 151 estimates rather than 1325
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7
Q

What are the advantages of the single index model?

A
  • Reducing the number of inputs

- Easier for security analysts to specialize

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8
Q

What are the disadvantages of the single index model?

A
  • Oversimplifying sources of real-world uncertainty
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9
Q

Can the index model be looked at as a regression?

A
  • Yes
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10
Q

regression model:

What is the Alpha?

A
  • representing the average firm-specific excess return when the market’s excess return is zero; intercept
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11
Q

regression model:

A
  • sensitivity of a stock to the market; the slope of the regression line
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