Flashcards in Topic 4: Index Models and Ethics Deck (11)

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1

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

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- 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)

2

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

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- We assume one macroeconomic indicator moves the security market as a whole

- We also assume all remaining uncertainty in stock returns is firm-specific

3

## When does it become the single factor model?

### - When we use a broad market index like S&P 500 as the common factor

4

## firm specific terms are assumed to be what?

### - Assumed to be uncorrelated with the market and with each other

5

## What is the only source of covariance in the returns?

### - So only source of covariance in the returns between the two stocks derives from their common dependence on the common factor

6

## What estimates are needed for the single index model?

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- 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

7

## What are the advantages of the single index model?

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- Reducing the number of inputs

- Easier for security analysts to specialize

8

## What are the disadvantages of the single index model?

### - Oversimplifying sources of real-world uncertainty

9

## Can the index model be looked at as a regression?

### - Yes

10

##
regression model:

What is the Alpha?

### - representing the average firm-specific excess return when the market’s excess return is zero; intercept

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