Topic 4: Index Models and Ethics Flashcards Preview

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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?

- 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?

- 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?

- 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?

- 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

11

regression model:

- sensitivity of a stock to the market; the slope of the regression line