Question

According to Markowitz full-covariance model or the single-index model, Which model will you perfer ?

Explain the advantages and disadvantages of the model you choose. (100words)

Answer 1

ANS: Single Index model is just like CAPM (Capital assets pricing model) which measure both risk & return of stock. The equation of this model is influenced by Risk-free return, Beta, Risk premium.

Single Index model assumes that there is only one macro-economic factor that causes systematic risk. hence, this is a simple model and not compatible to consider multiple risk factor.

Markowitz full- covariance model is influenced by Return, Standard deviation & co-efficient of correlation; this model helps to set efficient portfolio by finding out the trade-off between risk & return.

So, as per my opinion, it would better to select markowitz full-covariance model.

Advantages:

1. Markowitz theory is based on modern portfolio theory
2. Wealth maximisation by minimising the risk factor.
3. under this model performing assets as well as assets exposed to higher risk can be identified, which further can be replaced.
4. Tax advantage - it helps to identify the structure of investment to minimise the impact of taxes & increase the net return.

Disadvantages:

1. Large number of input data are required to calculate return & variance of return.
2. Frequent changes in structure of investment as markets scenario changes
3. one assumption of this theory doesnot hold good that securities of any size can be bought & sold, but it's not actually that because some securities has minimum order size.