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Asset Management

Asset Management. Lecture Three. Outline for today. Index model Single-factor index model Alpha and security analysis. Drawbacks of Markowitz. The model requires a huge number of estimates E.g. 50 stocks 50 estimates of E(r) 50 estimates of var(r) 1225 estimates of cov(ri, rj)

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Asset Management

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  1. Asset Management Lecture Three

  2. Outline for today • Index model • Single-factor index model • Alpha and security analysis

  3. Drawbacks of Markowitz • The model requires a huge number of estimates • E.g. 50 stocks • 50 estimates of E(r) • 50 estimates of var(r) • 1225 estimates of cov(ri, rj) • The model does not provide guideline to the forecasting of E(r)-rf

  4. Assumption: a broad market index like the S&P 500 is the common factor. ßi = index of a securities’ particular return to the factor m = Unanticipated movement in common factor that drives security returns ei = firm-specific surprise Single Factor Model

  5. Single-Index Model Non-market premium Systematic risk premium Regression Equation: Expected return-beta relationship:

  6. Single-Index Model Continued Risk and covariance: • Total risk = Systematic risk + Firm-specific risk: • Covariance = product of betas x market index risk: • Correlation = product of correlations with the market index

  7. Index Model and Diversification Portfolio’s variance: Variance of the equally weighted portfolio of firm-specific components: When n gets large, becomes negligible

  8. Figure 8.1 The Variance of an Equally Weighted Portfolio with Risk Coefficient βp in the Single-Factor Economy

  9. Example: HP and the S&P 500

  10. Example: HP and the S&P 500

  11. Table 8.1 Excel Output: Regression Statistics for the SCL of Hewlett-Packard

  12. Figure 8.4 Excess Returns on Portfolio Assets

  13. Alpha and Security Analysis Macroeconomic analysis is used to estimate the risk premium and risk of the market index Statistical analysis is used to estimate the beta coefficients of all securities and their residual variances, σ2 ( e i ) Developed from security analysis

  14. Alpha and Security Analysis The market-driven expected return is conditional on information common to all securities Security-specific expected return forecasts are derived from various security-valuation models • The alpha value distills the incremental risk premium attributable to private information Helps determine whether security is a good or bad buy

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