Lecture Overview:

• Implications of Portfolio Theory (2/3)
• Single factor model and index model
  • Risk and R^2

Basic Idea of Single Factor Model

Between he single factor model and CAPM:

• CAPM is a theoretical model based on many assumptions on the market and investors, and also provide economic meaning.
• Single factor model is a statistical model based on empirical data.

Markowitz Portfolio Theory requires intensive computations

• N expected returns
• N variances
• $(N^2-N)/2$ covariances
• In total of $2N+(N^2-N)/2$ estimates

From Markowitz Portfolio Theory to Single Factor Model

• Use statistical method to reduce computation