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Index Model

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

Benefits of Index Model


identify two sources of risk
market risk caused by common factors- nondiversifiable
firm-specific risk - diversifiable
reduces the number of parameters substantially - easier to forecast means and covariance
Specification of One Factor Index Model
The factor=broad based index such as S&P 500 index
ri
return of risky asset i

Model

rf

return of risk-free asset

Ri

Excess return (risk premium) of risky asset i

Rm

Excess return (risk premium) of the factor (such as S&P 500 index)

fi

firm specific factor


fi=i+ei
firm specific factor as a sum of its mean i and idiosyncratic shock e

E(Ri)

E(Rm)

E(fi)

risk(standard deviation) of Ri

risk(standard deviation) of Rm

ei

risk(standard deviation) of fi

ij

covariance between asset i and asset j

ij

correlation coefficient between asset i and asset j

standard deviation of idiosyncratic shock ei

Ri i i Rm ei
Assumptions

i andi are constant parameters


ei and Rm are not correlated: cov(ei, Rm )=0
ei and ej are not correlated each other: cov(ei, ej )=0

Interpretations

This is called the beta of asset i


represents the responsiveness of excess return of asset i to changes in the exce
if markets excess return changes by 1%, the excess return of asset

Macroeconomic factors affect the market's excess returns


i=1
stock i has the same sensitivity to the macrofactors as the market
i>1
stock i has a greater sensitivity to the macrofactors than the market (
i<1
stock i has a less sensitivity to the macrofactors than the market (def
i<0

excess return of stock i moves in the opposite direction of the market

This is called the alpha of asset i


represents the expected excess return of stock i beyond any return induced by m
expected excess return of stock i if the market factor is neutral, that is, if marke
a positive alpha implies expected excess return of stock i is greater than the ret
It is currently underpriced
a negative alpha implies expected excess return of stock i is lower than the retu
It is currently overpriced
Expected Excess Return of stock i

E ( Ri ) i i E ( Rm )

i i i m

iE(Rm)

component of excess return due to movements in the overall market


Risk of excess return of stock i

i2 i2 m2 e2
i

i
2

2
m

This is called the "systematic risk" or "market risk" or "non-diversifiab


The risk attributable to the uncertainty common to the entire market
depends on both the volatility of the market and sensitivity of the sto

ei2

This is called the "unsystematic risk" or "firm specific risk", or "divers


risk attributable to firm-specific risk factors
diverifiable risk means that this risk can be reduced through divers
while the nondiversifiable systematic risk cannot be reduc
Covariances of Excess Returns

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

Estimation of the One Factor Index Model


See the next sheet

i j m2
i2 m2 e2
i

m2

are correlated.
ects of common factors

t means and covariances

500 index)

nd idiosyncratic shock ei

diosyncratic shock ei

market index and firm-specific events are not correlated


firm-specific random events are not correlated each other

i to changes in the excess return of the market index


urn of asset i changes by i%

factors as the market

factors than the market (cyclical stocks)

ors than the market (defensive stocks)

e direction of the market (counter cyclical stocks)

d any return induced by markets excess return


neutral, that is, if markets excess return is zero.
k i is greater than the return determined by the common factor

k i is lower than the return determined by the common factor

nts in the overall market

t risk" or "non-diversifiable risk" of stock i


mon to the entire market
and sensitivity of the stock to the market movement
specific risk", or "diversifiable risk", or ,"unique risk", or "residual risk"

e reduced through diversification of a portfolio,


atic risk cannot be reduced by diversification.

i j m2

i2 m2 e2
i

m2

i j m
i2 m2 e2
i

Estimation of One Factor Index Model


Model
Ri i i Rm ei
Data Requirement: excess returns of stocks and market index (S&P 500 index)
Estimation method: Least Squares Estimation method
Intuitive Idea
Formula
Excel functions
Intercept( ) for alpha
Slope( ) for beta
Sumsq( ) for the estimation of variance of residuals

Use Regression function


This is an add-on. You need to download it unless your computer has
Estimate both Alpha and Beta
Click on Data Analysis - select regression - OK. This pops up a small w
Input: specify Y range and X range. If the names of variables are inclu
output: choose 'new work sheet'
residuals: choose 'line fit plots'
Click OK
This opens up the sheet that contains regression results (see the nex

nless your computer has already installed it in "Data Analysis" under "Data"

K. This pops up a small window


mes of variables are included, check 'labels'

sion results (see the next sheet regression results)

Excess Returns (%)=returns-Tbill3


date
IBM
McDonald S&P500
1/2/2004 IBM
McDonald S&P500
2/2/2004 -32.0515 118.0329 13.72084
3/1/2004 -58.93952 10.71587 -20.57072
4/1/2004 -48.87951 -57.55933
-21.089
5/3/2004 7.171126 -37.36615 13.48014
6/1/2004 -7.215241 -19.71323 20.31689
7/1/2004 -16.10987 68.1564 -42.47863
8/2/2004 -31.72675 -22.61279 1.264799
9/1/2004 13.21119 43.69884 9.586688
10/1/2004 54.37658 45.85905 15.0571
11/1/2004 60.34171 86.83885 44.24393
12/1/2004 53.18109 49.48224 36.75975
1/3/2005 -65.20048 10.17501 -32.67854
2/1/2005 -11.11037 22.68808 20.14406
3/1/2005 -18.21811 -73.13627 -25.68118
4/1/2005 -199.8399 -73.10604 -26.91031
5/2/2005 -12.58143 63.9728 33.10243
6/1/2005 -24.43105 -126.558 -3.141213
7/1/2005 146.4096 144.5578 39.94184
8/1/2005 -41.47513 45.5295 -16.90643
9/1/2005 -9.371537 35.07505 4.918728
10/3/2005 21.24016 -71.39995 -24.99889
11/1/2005 102.091 107.8727 38.34335
12/1/2005 -94.33994 -8.354286 -5.032875
1/3/2006 -17.38294 41.46575 26.32021
2/1/2006 -17.04564 -7.883237 -3.886284
3/1/2006 28.80917 -23.12472 8.805009
4/3/2006 -6.584838 2.435544 9.986792
5/1/2006 -36.03299 -53.24459 -41.82028
6/1/2006 -51.06162 10.69975 -4.68607
7/3/2006 4.250826 59.36784 1.152976
8/1/2006 55.26827 12.11577 20.56912
9/1/2006 9.569267 102.9417 24.66953
10/2/2006 147.2485 80.82187 32.88963
11/1/2006 -6.406276 25.69983 14.81993
12/1/2006 63.41523 62.63682 10.2889
1/3/2007 19.74508 -4.314443 11.8909
2/1/2007 -76.75508 -22.99009 -31.24537
3/1/2007 11.99607 32.5389 7.035946
4/2/2007 96.33138 81.24187 47.07882
5/1/2007 51.74214 51.78731 34.32907
6/1/2007 -19.82215 0.349883 -25.98957

7/2/2007
8/1/2007
9/4/2007
10/1/2007
11/1/2007
12/3/2007
1/2/2008
2/1/2008
3/3/2008
4/1/2008
5/1/2008
6/2/2008
7/1/2008
8/1/2008
9/2/2008
10/1/2008
11/3/2008
12/1/2008
1/2/2009
2/2/2009
3/2/2009
4/1/2009
5/1/2009
6/1/2009
7/1/2009
8/3/2009
9/1/2009
10/1/2009
11/2/2009
12/1/2009
1/4/2010
2/1/2010
3/1/2010
4/1/2010
5/3/2010
6/1/2010
7/1/2010
8/2/2010
9/1/2010
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
9/4/2012
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

Sample means and sample covariances of annualized monthly excess returns


Variances and covariances
IBM
McDonald S&P500
IBM
McDonald
mean i
8.187651 16.17155
3.6296
4148.19624 1082.377237
SD

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

fic shock) using the estimates of alpha and beta


s the same as the mean of the data
r variances, you need to press shift+ctrl+enter together

n
1
( Ri R i ) 2

2 i 1

beta, and error variance

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

Lower 95.0%Upper 95.0%


-4.140509604 15.02135
0.56980995 0.943967

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

PPC and CAL


Sample
mean
SD

Index Model
means
SD

IBM
McDonald S&P500
8.187650755 16.17155 3.62963631
64.40649222 54.25736 51.0846191

Variances and covariances


IBM
4148.19624
1082.37724
1975.20529

8.187650755 16.17155 3.62963631


64.76683845 54.62546 51.0846191

IBM
4194.74336
992.77378
1975.20529

Opportunity set (portfolio possibility curve PPC)


Use Excel's SOLVER
target mean
pt

Using Sample Moments (earlier results)


w2
w3
p

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

The PPC's are almost identical

Compute MVP
w1

Using sample moments


w2
w3
p

0.165355677 0.420106 0.4145388 9.652256 44.2655585

Optimal Portfolio

Using sample moments


w3
p

w1

w2

0.37370395

1.2602

Draw CAL

-0.6339043 21.13831 65.5068882


0
0

25

20

15

in

10

0
40

45

50

55

60

65

70

75

ances and covariances


McDonald
S&P500
1082.37724 1975.205 IBM
2943.86062 1311.651 McDonald
1311.65125 2609.638 S&P500
McDonald
S&P500
992.77378 1975.205 IBM
2983.94134 1311.651 McDonald
1311.65125 2609.638 S&P500

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

Using Index Model Moments


w2
w3
p
-0.065184
0.007212
0.079607
0.152003
0.224398
0.296794
0.369189
0.441585
0.51398
0.586376
0.658771
0.731167
0.803562
0.875958
0.948353
1.020749
1.093144
1.16554
1.237935
1.310331
1.382726

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

Using Index Model Moments


w2
w3
p

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

0.176049 0.418289 0.405662 9.678213 44.21553

25

20

15

10

0
40

45

50

70

w1

w2

Using Index Model Moments


w3
p
p

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

Textbook Table 5.2


Active Portfolio
Benchmark
Portfolio
Google
A. Input data
Risk premium
SD
Sharpe ratio
alpha
Beta
Residual SD
Info ratio
alpha/residual variance

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

C. Optimal Portfolio with Google and Dell in active portfolio


active portfolio weights
alpha_a of active portfolio
beta_a of active portfolio
residual SD of Active Portfolio
Information ratio

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 )

Textbook Table 6.2


Active Portfolio
Benchmark
Portfolio
A. Input data
Risk premium
SD
Sharpe ratio
alpha
Beta
Residual SD
Info ratio
alpha/residual variance

Google

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

0.001919 0.047586 0.025092


0.012873
0.010301

( * ) 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