Applications in Finance Market Model

The document discusses the market model, which assumes that a stock's rate of return is linearly related to the overall market rate of return. It estimates the market model for Nortel stock over 5 years. The slope coefficient b1 measures a stock's sensitivity to market changes, while the coefficient of determination R2 measures the proportion of risk explained by market movements. For Nortel, b1 was 0.8877 and R2 was 31.37%, indicating most risk was firm-specific rather than market-related.

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Applications in Finance Market Model

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Ranjani C Narayan

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Amity Business School

Applications of Regression in
Finance : Market Model
Dr RS Rai
Department of Decision Sciences
Amity Business School, Noida
Amity Business School

Introduction
 In this lecture we describe one of the most important applications of
simple linear regression. It is well-known and often applied market
model. This model assumes that the rate of return on a stock is
linearly related to the rate of return on the overall market. The
mathematical description of the model is

𝑅 = 𝛽0 + 𝛽1 𝑅𝑚 + 𝜀

 Where R is the return on a particular stock and 𝑅𝑚 is the return on

some major stock index, such as New York Stock Exchange
Composite Index.
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Introduction
 The coefficient 𝛽1 is called the stock’s beta coefficient, which measures
how sensitive the stock’s rate of return is to changes in the level of the
overall market. For example, if 𝛽1 is greater than 1, the stock’s rate of
return is more sensitive to changes in the level of the overall market than
is the average stock.
 To illustrate, suppose that 𝛽1 = 2. Then a 1% increase in the index results
in an average increase of 2% in the stock’s return.
 Thus, a stock with a beta coefficient greater than 1 will tend to be more
volatile than the market.

 The regression analysis produces 𝑏1 , which is an estimate of a stock’s

beta. The coefficient of determination is also an important part of the
financial-statistical analysis.
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Market Model for Nortel

 The monthly return for Nortel stock and for the overall market as
measured by the Toronto Stock Exchange (TSE) Index over a 5-
year period were recorded.
 we estimated the market model and analyzed the results.
 A regression analysis was performed and the Excel, Minitab and
SPSS outputs are shown here.
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MS- Excel
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Minitab
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SPSS
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Interpretation
 We can interpret the statistics provided in the
printout in the same way we’ve been doing thus
far.
 However, we’re especially interested in the
financial aspects of this procedure.
 In particular, the financial analysis focuses on two
statistics, 𝑏1 and 𝑅2 .
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Slope Coefficient 𝑏1
 The slope coefficient 𝑏1 is a measure of the stock’s
market-related (or systematic) risk because it measures
the volatility of the stock price that is related to the overall
market volatility.
 We note that the slope coefficient for Nortel is .8877.
 We interpret this to mean that in this sample for each 1%
increase in the TSE return, the average increase in
Nortel’s return is .8877%.
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Coefficient of Determination
 The coefficient of determination measures the proportion
of the total risk that is market-related.
 In this case, we see that 31.37% of Nortel’s total risk is
market related.
 That is, 31.37% of the variation in Nortel’s returns is
explained by the variation in the TSE’s returns.
 The remaining 68.63% is the proportion of the risk that is
associated with events specific to Nortel, rather than the
market.
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Coefficient of Determination
 A financial analyst (and most everyone else) calls this the
firm-specific (or nonsystematic) risk.
 The firm-specific risk is attributable to variables and
events not included in the market model, such as the
effectiveness of Nortel’s sales force and mangers.
 This is the part of the risk that can be “diversified away”
by creating a portfolio of stocks. We cannot, however,
diversify away the part of the risk that is market-related.
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Summery of Market Model

 When a portfolio has been created, we can estimate its beta by
averaging the betas of the stocks that compose the portfolio.
 If an investor believes that the market is likely to rise, a portfolio
with a beta coefficient greater than 1 is desirable.
 Risk-averse investors or ones who believe that the market will fall
will seek out portfolios with betas less than 1.