Week 9: Week 9 Single Factor Models, Single Index Models, and CAPM Flashcards
What is the Single Factor Model (SFM) ?
Firms in stock markets are all affected by a series of common economic factors, e.g., business cycles; interest rates; cost of labour, etc) whcih are Sources of systematic risk. Beta (β) - the sensitivity of stock returns to changes in these market factors.
The Single Factor Model (SFM) The SFM argues that all relevant economic factors (systematic risk) can be summarized by just one macroeconomic indicator.
and that All remaining uncertainty/variation in stock returns is firm-specific without affecting the broad economy (e.g., price of beef for Tesco or price of coffee beans for Costa).
What is the Single Index Model (SIM)?
The way of making the SFM works, is to assert that the return on a broad index of securities is a valid proxy for the common macro factors .i.e. replace the common macro factor (F) with a broad index of securities that can mimic the common macro factor such as the FTSE100 or S&P500 indexes.
what are the advanatges of the single index model?
The SIM:
Reduces the number of estimates required, compared to the efficient frontier of Markowitz.
In Markowitz’s approach, analysts cannot specialise by industry.
What are the drawbacks of the single index model?
Drawbacks:
Uncertainty is classified into macro vs. firm-specific risk – is this realistic?
What about industry events that affect firms within an industry without affecting the broad economy?
e.g. a new method to store hydrogen safely would affect car and oil industries without affecting the whole economy.
Can ignore negative correlation between securities (i.e., the effect of diversification).
So, the SIM optimal portfolio can be significantly inferior to that of the Markowitz model when stocks are correlated.
as n increases what happens to total vairance in the single index model?
As n increases, total variance approaches the systematic variance – that is why we use a broad index and remove non-systematic risk.
What are the eight main assumptions of CAPM?
Main Assumptions of CAPM:
1) Many investors
Individual wealth is small – price takers, i.e., they cannot dramatically influence the price of any asset to their advantage.
2) Investors plan for only one holding period. Myopic behaviour – no long term, multi-period investing.
3) Investments are limited to a universe of publicly-traded financial assets.
Stocks, bonds, risk-free assets.
Rules out investment in non-traded assets.
4) No transaction costs and taxes paid by investors.
5) All investors are rational mean-variance optimizers. All use the Markowitz portfolio selection model and want to get the highest return for a level of risk.
6) All investors analyse securities the same way. Derive the same input list into the Markowitz model. Homogeneous expectations – same expectations.
7) All investors choose to hold a portfolio of risky assets in proportions identical to the market portfolio (M).
8) M (the portfolio that has the highest Sharpe ratio) will be the tangency portfolio to the optimal Capital Allocation Line (CAL). Capital Market Line is the best attainable Capital Allocation Line (CAL).
