What is the simplifying assumption that the single index model makes, and what is the benefit...

What is the simplifying assumption that the single index model makes, and what is the benefit of that assumption?

Expert Solution

To simplify analysis, the single-index model assumes that there is only 1 macroeconomic factor that causes the systematic risk affecting all stock returns and this factor can be represented by the rate of return on a market index, such as the S&P 500.

Single index Model assumes that the macro factor can be represented by a broad index of stock returns. It drastically reduces the necessary inputs in the Markowitz portfolio selection procedure. It also aids in specialization of labor in security analysis.

It is better because by using the full covariance matrix invokes estimation risk of thousands of terms. Also it is practical and decentralizes macro and security analysis.

The Single Index Model is a simplified analysis of Portfolio Selection Model. To measure both Risk and Return on the stock. The Single Index Model greatly reduces the number of calculations that would otherwise have to be made for a large portfolio of thousands of securities.

Rahul Sunny answered 2 years ago

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