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Idea: There are two types of factors that determine the returns (or prices) of stocks
1. common factors: affect all stocks
Single-index (Single Factor) model: only one common factor
Multifactor index model - many common factors
2. firm-specific (idiosyncratic) factor: affects only one firm
these factors are assumed to be uncorrelated
Implications
common factors affect all stock prices, and hence the stock prices are correlated.
that is, covariances among stock prices are determined by the effects of common factors
Model
rf
Ri
Rm
Excess return (risk premium) of the factor (such as S&P 500 index)
fi
E(Ri)
E(Rm)
E(fi)
risk(standard deviation) of Ri
risk(standard deviation) of Rm
ei
risk(standard deviation) of fi
ij
ij
Ri i i Rm ei
Assumptions
Interpretations
E ( Ri ) i i E ( Rm )
i i i m
iE(Rm)
i2 i2 m2 e2
i
i
2
2
m
ei2
ij cov( Ri , R j ) i j m2
im
im cov( Ri , Rm ) i m2
ij
cov( Ri , Rm )
corr ( Ri , Rm )
SD ( Ri ) SD ( Rm ) i m
i j m2
i2 m2 e2
i
m2
are correlated.
ects of common factors
500 index)
nd idiosyncratic shock ei
diosyncratic shock ei
i j m2
i2 m2 e2
i
m2
i j m
i2 m2 e2
i
nless your computer has already installed it in "Data Analysis" under "Data"
7/2/2007
8/1/2007
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10/1/2010
11/1/2010
12/1/2010
1/3/2011
2/1/2011
3/1/2011
56.80988
65.68292
7.554921
-21.01856
-112.4132
30.27359
-13.70609
78.38523
12.24538
56.62039
90.30734
-102.9481
94.05365
-55.88094
-48.12739
-246.8094
-141.0836
37.63529
106.6299
11.25904
63.2529
78.10379
41.912
-21.12156
154.9625
6.742948
15.69962
9.944358
62.74256
43.18044
-78.1271
52.27345
10.08925
6.907021
-29.0542
-17.15422
47.6672
-43.68127
107.1028
84.56812
-12.81234
44.86445
124.4107
3.753244
8.725237
-73.39143
30.6228
123.0878
112.5523
1.914118
6.094633
-111.3087
17.99623
35.4074
80.87724
-7.000513
-57.20389
74.55247
50.22703
-7.04133
-74.01349
27.79621
70.12458
-80.56438
-109.6317
53.04679
-28.32068
128.1595
-21.06793
-50.81694
36.48835
17.54485
32.36243
106.0646
-15.41
-0.276099
37.49807
53.91916
69.42556
-53.99036
-17.9801
70.14384
66.63353
23.6445
52.36669
17.47219
-23.67268
-48.49728
42.61945
6.408707
-43.19829
11.23631
39.0628
13.8868
-56.12211
-13.35419
-76.14617
-43.83339
-8.4115
55.76602
11.07898
-105.0149
-13.46125
12.9086
-110.0797
-203.9794
-90.00884
9.355879
-102.9188
-132.2175
102.2754
112.5501
63.51771
0.055002
88.79011
40.10221
42.74806
-23.78438
68.7868
21.27472
-44.42911
34.10643
70.40564
17.55119
-98.5311
-64.77885
82.3734
-57.099
104.9113
44.09713
-2.888339
78.22009
27.02471
38.2179
-1.356762
4/1/2011
5/2/2011
6/1/2011
7/1/2011
8/1/2011
9/1/2011
10/3/2011
11/1/2011
12/1/2011
1/3/2012
2/1/2012
3/1/2012
4/2/2012
5/1/2012
6/1/2012
7/2/2012
8/1/2012
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10/1/2012
11/1/2012
12/3/2012
1/2/2013
2/1/2013
3/1/2013
4/1/2013
5/1/2013
6/3/2013
7/1/2013
8/1/2013
9/3/2013
55.19456
-6.358109
18.57152
72.03273
-60.66833
20.65598
66.96633
26.7673
-26.26864
56.8245
30.42392
72.65297
-9.117212
-77.57847
16.57932
2.347315
-1.916094
77.47323
-74.79809
-22.51697
9.276492
72.09135
-8.308918
74.4198
-60.61385
38.24705
-97.61993
24.63396
-73.00336
19.13839
35.0337
58.71862
40.82785
30.78401
62.91082
-34.36034
68.66785
43.89915
60.40828
-15.32709
11.05075
-14.29019
-8.040625
-91.34377
-11.00163
11.19412
11.08881
30.23642
-64.83702
14.05286
16.02601
96.20308
17.31187
47.33028
29.41411
-56.50076
30.13789
-11.28122
-36.17938
23.50692
34.13443
-16.24111
-21.94901
-25.80932
-68.16932
-86.12442
129.2476
-6.080374
10.2293
52.26962
48.61734
37.51885
-9.076997
-75.27081
47.37591
15.01717
23.61603
28.97331
-23.84728
3.326044
8.411973
60.44368
13.17272
43.09536
21.64292
24.87534
-18.04919
59.31453
-37.59762
35.67937
use average8.187651
use stdev.s 64.68591
154.9625
-246.8094
16.17155
54.49275
144.5578
-126.558
3.629636
51.30625
129.2476
-203.9794
64.40649 54.25736
51.0846
1082.377237 2943.860622
1975.205289 1311.651250
number of sample=
116
Estimation of alpha and beta using excel functions intercept and slope
IBM
McDonald
alpha
5.440421 14.34723
use 'intercept' function
beta
0.756889 0.502618
use 'slope' function
compute predicted means and error variance (variance of firm-specific shock) using the es
means
8.187651 16.17155
Note that the predicted mean is the same as the mean
error var
2679.626 2242.505
NOTE: to compute the error variances, you need t
R i i i Rm
e2
i
n
1
( Ri R i ) 2
n 2 i 1
compute variance and covariance using the estimates of alpha and beta, and error varianc
IBM
McDonald S&P500
var( Ri ) i2 m2 e2i
IBM
4194.743 992.7738 1975.2053
McDonald 992.7738 2983.941 1311.6513
cov( Ri , R j ) i j m2 , i j
S&P500
1975.205 1311.651 2609.6383
cov( Ri , Rm ) i m2
Estimation with Excel's Regression( ) function in Data Analysis
SUMMARY OUTPUT
IBM
Regression Statistics
Multiple R 0.600333
R Square
0.3604
Adjusted R 0.35479
Standard Er51.95896
Observatio
116
ANOVA
df
Regression
Residual
Total
SS
MS
F
Significance F
1 173421.2 173421.185 64.23642 1.05806E-012
114 307769.6 2699.73314
115 481190.8
Coefficients
Standard Error t Stat
P-value
Lower 95%
Upper 95%
Intercept 5.440421 4.83643 1.12488361 0.263001 -4.140509604 15.02135097
S&P500
0.756889 0.094437 8.01476247 1.06E-012 0.56980995
0.9439671
RESIDUAL OUTPUT
Observation
Predicted IBMResiduals
1 15.82556 -47.87706
2 -10.12932 -48.8102
3 -10.5216 -38.35791
4 15.64338 -8.472254
5 20.81804 -28.03329
6 -26.71116 10.60129
7 6.397733 -38.12448
8 12.69647 0.514712
9 16.83696 37.53961
10 38.92814 21.41357
11 33.26346 19.91764
12 -19.29359 -45.90689
13 20.68723 -31.7976
14 -13.99737 -4.220743
15 -14.92768 -184.9122
16 30.49527 -43.0767
17 3.062873 -27.49392
18 35.67194 110.7377
19 -7.355863 -34.11926
20 9.16335 -18.53489
21 -13.48095 34.72111
22 34.46206 67.62892
23 1.631095 -95.97104
24 25.36188 -42.74482
25 2.498937 -19.54458
26 12.10483 16.70434
27 12.99931 -19.58415
28 -26.21287 -9.820121
29 1.893588 -52.95521
30 6.313095 -2.062269
31 21.00895 34.25932
32 24.1125 -14.54324
33 30.33421 116.9143
34 16.65746 -23.06373
35 13.22797 50.18726
36 14.44051 5.304576
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
-18.20884
10.76585
41.07384
31.4237
-14.23079
-27.25587
13.94506
35.00661
15.95118
-37.03776
-4.66721
-52.19374
-27.73657
-0.926147
47.64908
13.82598
-74.04412
-4.748245
15.21079
-77.87767
-148.9493
-62.68624
12.52178
-72.45765
-94.63347
82.8515
90.62829
53.51625
5.482051
72.64463
35.79332
37.79594
-12.56171
57.50436
21.54301
-28.18747
31.25519
58.72964
18.72472
-69.13664
-43.58995
67.7879
-37.77716
84.8466
38.81703
-58.54623
1.23022
55.25754
20.31843
-5.591365
84.06575
51.73787
-27.45169
-36.96975
-75.37543
34.9408
38.48765
106.1218
13.17153
8.971308
76.48137
-28.90395
98.8019
-71.09173
29.75029
-97.86015
-78.39732
25.11351
179.0876
105.8925
-19.59861
-12.5245
-11.60425
-26.60361
82.31787
-29.05037
-22.09632
22.50606
5.238203
21.63743
-49.93963
21.01826
-48.64039
-11.8177
40.08243
26.43573
-20.1207
-5.904111
22.25622
45.75109
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
3.25427
64.64431
25.89511
34.36711
4.413503
31.27638
-6.852292
-11.17253
-14.09436
-46.15615
-59.74616
103.2665
0.838255
13.18286
45.00269
42.23833
33.83801
-1.429854
-51.53119
41.2987
16.80674
23.31513
27.36999
-12.60932
7.957865
11.80735
51.18955
15.4107
38.0588
21.8217
24.26828
-8.220805
50.33491
-23.01678
32.44573
-16.06661
-19.77986
98.51554
-30.61387
4.311734
23.91818
0.494182
29.74405
86.12709
-14.51218
80.40215
-36.30016
25.92905
-39.4515
11.8218
-11.81441
38.81496
-7.687358
-26.04728
-24.71938
-14.45943
-25.23122
50.10325
-62.18877
-30.47484
-2.530854
20.9018
-23.71962
36.361
-82.43554
13.97877
-89.39913
-25.70095
-49.98658
-13.30733
S&P500
1975.205289 IBM
1311.65125 McDonald
2609.638307 S&P500
n
1
( Ri R i ) 2
2 i 1
m2 , i j
200
IBM
150
100
50
0
-250 -200 -150 -100 -50-50 0
S&P500
50
100 150
-100
-150
-200
-250
-300
IBM
Predicted IBM
SUMMARY OUTPUT
McDonald
Regression Statistics
Multiple R 0.473227
R Square 0.223944
Adjusted R 0.217136
Standard Er48.21495
Observatio
116
ANOVA
df
Regression
Residual
Total
SS
MS
F
Significance F
1 76474.11 76474.11 32.89659 8.11E-008
114 265013.7 2324.682
115 341487.8
Coefficients
Standard Error t Stat
P-value Lower 95%Upper 95%
Lower 95.0%
Intercept 14.34723 4.487932 3.196846 0.001798 5.456669 23.23778 5.456669
S&P500
0.502618 0.087632 5.735555 8.11E-008 0.32902 0.676216 0.32902
Upper 95.0%
23.23778
0.676216
Index Model
means
SD
IBM
McDonald S&P500
8.187650755 16.17155 3.62963631
64.40649222 54.25736 51.0846191
IBM
4194.74336
992.77378
1975.20529
w1
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
0.044688585
0.06282789
0.080967171
0.09910641
0.117245682
0.135384952
0.153524226
0.171663523
0.189802767
0.207942035
0.226081306
0.244220585
0.262359843
0.280499155
0.298638384
0.316777656
0.33491693
0.353056167
0.371195489
0.389334773
0.407473877
-0.066443
0.006697
0.079838
0.152978
0.226118
0.299259
0.372399
0.44554
0.51868
0.591821
0.664961
0.738101
0.811242
0.884382
0.957523
1.030663
1.103804
1.176944
1.250085
1.323225
1.396365
1.02175489
0.93047498
0.83919526
0.74791569
0.65663598
0.56535627
0.47407655
0.38279669
0.29151712
0.20023741
0.1089577
0.01767798
-0.0736017
-0.1648816
-0.2561611
-0.3474409
-0.4387206
-0.5300003
-0.62128
-0.7125599
-0.8038393
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
52.3598761
50.2402905
48.3938569
46.852877
45.6482906
44.8072392
44.3504097
44.2896932
44.6267059
45.3525827
46.4490962
47.8907948
49.6476165
51.6874421
53.9781875
56.4893445
59.1928649
62.0636156
65.07947
68.2211933
71.4721707
Compute MVP
w1
Optimal Portfolio
w1
w2
0.37370395
1.2602
Draw CAL
25
20
15
in
10
0
40
45
50
55
60
65
70
75
w1
0.041223
0.061412
0.081601
0.10179
0.121979
0.142168
0.162357
0.182546
0.202735
0.222924
0.243113
0.263302
0.283491
0.30368
0.323869
0.344058
0.364247
0.384436
0.404625
0.424814
0.445004
w1
1.023961
0.931377
0.838792
0.746208
0.653623
0.561038
0.468454
0.375869
0.283285
0.1907
0.098116
0.005531
-0.087053
-0.179638
-0.272223
-0.364807
-0.457392
-0.549976
-0.642561
-0.735145
-0.82773
p
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
52.36719
50.24133
48.38767
46.83854
45.62496
44.77423
44.30726
44.2362
44.56294
45.27888
46.36598
47.79893
49.54774
51.58028
53.86445
56.36966
59.0678
61.93366
64.94503
68.08262
71.32977
25
20
15
10
0
40
45
50
70
w1
w2
Sharpe
Sharpe
0.32268828 0.407066 1.246699 -0.653766 21.12104 65.31845 0.323355
0.00
0.00
sample
index
CAL sample
CAL index
75
sample
index
45
50
55
60
65
70
75
0.7
4.31
0.16
2.2
11.39
Dell
1.74
10.49
1.04
0.75
1.65
1.41
9.01
8.55
0.115427 0.087719
0.012811 0.01026
informatio n ratio
Portfolio construction
B. Optimal portfolio with Google only in active portfolio
w0
w*
sharpe ratio
1 / e2
w1
(1 1 )(1 / e2 ) ( m / m2 )
1
0.33997 0.272261
0.56359287 0.436407
0.19729
S S
e
1
2
p
0.555297 0.444703
w1
0.911036
1.543271
6.284033
0.144976
Complete portfolio
weight of active portfolio
weight of benchmark
0.917347
0.082653
weight on Google
weight on Dell
0.5094
0.407947
Sharpe ratio
0.215912
i
e
2
m
a w11 w
1 / e2
1 / e2 2 / e2
1
e2 w12 e2
a / e2
wa
(1 a )( a / e2 ) ( m / m2 )
a
2
cp
S
e
a
2
m
ratio
i
e
1 / e2
e2 ) ( m / m2 )
1
a w11 w2 2 ,
a
1 / e21
w
m / m2
0
1
a w1 1 w2 2
e2 w12 e2 w22 e2
e2
) ( m / m2 )
w10
w1
,
1 w10 (1 1 )
0.7
4.31
0.16
Dell
2.2
11.39
1.74
10.49
1.04
0.75
1.65
1.41
9.01
8.55
0.115427 0.087719
0.012811 0.01026
informatio n ratio
i
e
Ri i i Rm ei
Covariance matrix based on the single index model
Benchmark
Google
Dell
2
2
2
2
Benchmark
18.5761 30.65057 26.1923 i i m ei
Google
30.650565 131.7535 43.2173
2
Dell
26.192301 43.2173 110.0336 im i m
B. Optimal portfolio with Google only in active portfolio
weights
0.5608959253 0.439104
mean of portfolio
1.3586561121
SD of portfolio
6.8077743587
Sharpe ratio
0.1995741986
w1
1 m2 m 1m
1 m2 m 12 ( 1 m ) 1m
C. Optimal Portfolio with Google and Dell in active portfolio: Use SOLVER
weights
0.0761002601 0.510435 0.408448
mean
1.8869272071
SD
8.649969142
Sharpe ratio
0.2181426519
Theoretical Solution
0.7
2.2
1.74
1
1
1
V 1
' V 1
' V 1
( * ) 2
'V
'V
p
mean
1.896440747
*p
( *p ) 2
1
1
2
( ' V )
' V 1
'V
SD
8.693580697
Sharpe rati 0.218142652
weights
0.0764839403 0.513009 0.410507
1
atio n ratio
i
e
12 1 2 m2
1 m2 m 1m
m 12 ( 1 m ) 1m
' V 1
( p )
2
)
' V 1
V 1
w
' V 1
*
p