Flashcards in Topic 4: Index Models and Ethics Deck (11)
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)
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
When does it become the single factor model?
- When we use a broad market index like S&P 500 as the common factor
firm specific terms are assumed to be what?
- Assumed to be uncorrelated with the market and with each other
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
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
What are the advantages of the single index model?
- Reducing the number of inputs
- Easier for security analysts to specialize
What are the disadvantages of the single index model?
- Oversimplifying sources of real-world uncertainty
Can the index model be looked at as a regression?
What is the Alpha?
- representing the average firm-specific excess return when the market’s excess return is zero; intercept