THE CORRELATION STRUCTURE OF SECURITY

RETURNS :
MULTIINDEX MODELS AND GROUPING
TECHNIQUES

Dipankar Das

23013

Touhidul Huq Khan

23007

CHAPTER HIGHLIGHTS

Multi-Index Models
General Multi-index Models
Industry Index Models
Effectiveness of Multi Index Models
Average Correlation Models
Mixed models
Fundamental Multi Index Models

MULTI-INDEX MODELS

Multi-index models are an attempt to capture some of the

nonmarket influences that cause securities to move together.
Multi-index models introduce extra indexes in the hope of
capturing additional information.
Multi-index models can be used to form expectations about
returns and study the impact of events.

MULTI-INDEX MODELS(contd.)

The assumption underlying the single-index model is that

stock prices move together only because of common
movement with the market. Many researchers have found that
there are influences beyond the market that cause stocks to
move together.

General Multi-index Models

Let us hypothesize that the return on any stock is a function of the return
on the market, changes in the level of interest rates, and a set of industry
indexes. If Ri is the return on stock i, then the return on stock i can be
related to the influences that affect its return in the following way:
Ri = ai* + bi*1I*1 + bi*2I*2 +..........+ bi*L IL* + ci

I*j is the actual level of index j

bi*j is a measure of the responsiveness of the return on stock i to changes

in the index j.

a*i is the expected value of the unique return.

ci is the random component of the unique return.

General Multi-index
Models(contd.)

Although a multi-index model of this type can be employed directly, the

model would have some very convenient mathematical properties if the
indexes were uncorrelated. Using this methodology, the equation can be
rewritten as
Ri = ai + bi1I1 + bi2 I2 + bi3I3 +........+ biL IL + ci
where all Ij are uncorrelated with each other. The new indexes still have an
economic interpretation. Assume I*1 was a stock market index and I*2 an
index of interest rates. I2 is now an index of the difference between actual
interest rates and the level of interest rates that would be expected given the
rate of return on the stock market (I1). Similarly, bi2 becomes a measure of
the sensitivity of the return on stock i to this difference.

General Multi-index
Models(contd.)

Not only is it convenient to make the indexes uncorrelated,

but it is also convenient to have the residual uncorrelated with
each index. Formally, this implies that E[ci(Ij - j)]=0 for all j.
BASIC EQUATION:
Ri = ai + bi1I1 + bi2 I2 + bi3I3 +L+ biL IL + ci
for all stocks i =1,...,N

General Multi-index
Models(contd.)
BY DEFINITION
1. Residual variance of stock i equals
2. Variance of index j equals

where i=1,...,N.

where j=1,...,L.

BY CONSTRUCTION
1. Mean of ci equals E(ci) =0 for all stocks, where i =1, ..., N.

2. Covariance between indexes j and k equals

indexes,where j =1, ..., L and k =1, ..., L (j k).

for all

3. Covariance between the residual for stock i and index j equals

for all stocks and indexes, where i =1, ..., N and j =1, ..., L.

General Multi-index
Models(contd.)
BY ASSUMPTION
1. Covariance between ci and cj is zero (E(cicj)=0)
for all stocks where i =1, ..., N and j=1, ..., N ( j i).

General Multi-index
Models(contd.)

The expected return, variance, and covariance

among securities when the multi-index model
describes the return structure are equal to the
following:
1. Expected return is
2. Variance of return is
3. Covariance between security i and j is

Industry Index Models

If we hypothesize that the correlation between securities is

caused by a market effect and industry effects, our general
multi-index model could be written as
Ri = ai + bimIm + bi1I1 + bi2 I2 +....+ biL IL + ci
where
Im is the market index
Ij are industry indexes that are constrained to be
uncorrelated with the market and uncorrelated with each
other

Industry Index Models(contd.)

Model assume that each industry index has been constructed to
be un correlated with market and other industries.
Covariance between security i and j

EFFECTIVENESS OF MULTI
INDEX MODEL

Multi index model lie in an intermediate position between the full historical
correlation matrix itself and the single index model.

The more indexes added the more complex things become and the more
accurately the historical matrix is reproduced but not ensured about the
future correlation matrices.

Elton and Gruber test using the principle components analysis

1.

Adding additional indexes derived from past correlation matrix to the

single index model led to a decrease in performance.

2.

It better explanation of the historical correlation matrix

3.

But led poorer prediction of the future correlation matrix and selection of
portfolio that has lower return at each risk level.

4.

adding indexes increase random noise

EFFECTIVENESS OF MULTI
INDEX MODEL(contd.)

The evidence that a generalized multi-index model, where the indexes are
extracted according to explanatory power from past data, does not perform
as well as a single-index model is very strong.

This does not imply that a different form of a multi-index model might not
work better than a single-index model. Indexes based on interest rates or
oil prices or other fundamental factors affecting different companies in
different ways may lead to better performance.

AVERAGE CORRELATION
MODELS

The most aggregate type of averaging that can be done is to

use the average of all pair wise correlation coefficients over
some past period as a forecast of each pair wise correlation
coefficient for the future.
This is equivalent to the assumption that the past correlation
matrix contains information about what the average correlation
will be in the future but no information about individual
differences from this average. This model can be thought of as
a naive model against which more elaborate models should be
judged. We refer to this model as the overall mean model.

A more disaggregate averaging model would be to assume

that there was a common mean correlation within and among
groups of stocks. For example, if we were to employ the idea
of traditional industries as a method of grouping, we would
assume that the correlation between any two steel stocks was
the same as the correlation between any other two steel stocks
and was equal to the average historical correlation among steel
stocks.

Similarly, the correlation among any steel stocks and any

chemical stocks is assumed to be equal to the correlation
between any other steel stock and any other chemical stock
and is set equal to the average of the correlations between
each chemical and each steel stock. When this is done, with
respect to traditional industry classifications, it will be referred
to as the traditional mean model

MIXED MODELS

In a mixed model, the single-index model is used as the basic

starting point. However, rather than assume that the extra
market covariance is zero, a second model is constructed to
explain extra market covariance. If we consider a general
multi-index model where the first index is the market, then we
can consider all other indexes as indexes of extra market
covariance.
Rosenbergs method of relating the beta to a set of
fundamental and technical data is used for calculating the
extra market covariance.

Touhidul Huq Khan

ID# 23007

FUNDAMENTAL MULTI-INDEX MODELS

FamaFrench Models

Fama and French set the basis for a multi-index model

based on firm characteristics.
size (market capitalization) and the ratio of book value of
equity to the market value of equity have a strong role in
determining the cross section of average return on common
stocks.
Incorporated size index and book value to market value of
equity ratio index into the multi-index model.
The concept behind the size and book to market indexes is
to form portfolios that will have returns that mimic the impact
of the variables.
Constructing each of these variables is a two-step process:
Step 1:
Five portfolios are using stocks listed at NYSE, NASDAQ,
etc.
Stocks are categorized based on two criteria size and BV
to MV ratio

FUNDAMENTAL MULTI-INDEX MODELS

Five portfolios are using stocks listed at NYSE,

NASDAQ, etc.
Stocks are categorized based on two criteria size
and BV to MV ratio
Based on size, two groups are defined one group
containing the stocks that have a size larger than the
median size of the stock on NYSE and a second
group containing the all smaller stocks.
Based on BE/ME, stocks are categorized into three
groups which are defined by the break points of lowest
30%, middle 40% & highest 30% of the stock of
NYSE.
This two way classification is then used to form five
marketable securities.

FUNDAMENTAL MULTI-INDEX MODELS

Step 2:

Define the actual indexes used to explain return.

The size variable is formulated as small minus big
(SMB) and is defined as the difference between two
portfolios. Avg. return of 3 small portfolios less avg.
return of large portfolios.
Similarly, BE/ME is defined as high minus low.
Using the above two variable size and BE/ME, a
third variable is used which is simply the return on the
market minus the Treasury bill rate.

FUNDAMENTAL MULTI-INDEX MODELS

Chen, Roll and Ross Model
This model is based on two concepts.
The first is that the value of a share of stock is equal
to the present value of future cash flows to the equity
holder. Thus an influence that affects either the size of
future cash flows or discount rates used to value cash
flows impacts price.
Once a set of variables that affects prices is identified,
the second concept comes into play. It argues that
because current beliefs about these variables are
incorporated in price, only innovations or
unexpected changes in these variables can affect
return.

FUNDAMENTAL MULTI-INDEX MODELS

Five variables are sufficient to describe the

security returns:
2

variables related with the discount rate used

to find PV of CF
1 related to both size of CF and discount rates
1 related to on CF
1 related to capture the impact of the market
which is not incorporated in the first 4 variables.

FUNDAMENTAL MULTI-INDEX MODELS

RMRF= 0.00221.33I1+ 0.56I2+2.29I30.93I4
R2 = 0.24
Where,

I1=one-half of 1% plus the return on long-term government bonds minus

the return on long-term corporate bonds
I2=return on long-term government bonds minus return on the one-month
Treasury bill one month in the future
I3=rate of inflation expected at the beginning of the month minus the
actual rate of inflation realized at the end of the month
I4=expected long-run growth rate in real final sales expected at the
beginning of the month minus the expected long-run growth rate in real
final rates expected at the end of the month
The last variable, I5, is simply the difference between the excess return
on the market for any month and the excess return predicted from the
estimated equation or the time series of

I5 = (Rm RF) (0.0022 1.33I1 + 0.56I2 + 2.29I3 0.93I4)