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This chapter a simplifying assumption that at once eases our computational burden and offers significant new insights into the nature of systematic risk versus firm-specific risk. This abstraction is the notion of an “index model,” specifying the process by which security returns are generated. | CHAPTER 10 INDEX MODLES 1 INDEX MODELS A single-Index Security Market The CAPM and the Index Model The Industry Version of the Index Model Index Models and Tracking Portfolios 2 A single-Index Security Market Systematic Risk versus Firm-Specific Risk Estimating the Index Model The Index Model and Diversification 3 Systematic Risk versus FirmSpecific Risk The success of a portfolio selection rule depends on the quality of the input list, that is, the estimates of expected security returns and the covariance matrix. In the long run, efficient portfolios will beat portfolios with les reliable input lists and consequently inferior reward-to-risk trade-offs. 4 Systematic Risk versus FirmSpecific Risk Suppose that we summarize all relevant economic factors by one macroeconomic indicator and assume that it moves the security market as a whole. We further assume that, beyond this common effect, all remaining uncertainty in stock returns is firm specific; that is, there is no other source of correlation between .
