What was the purpose for William Sharpe's development of the single index market model?

Question

What will be an ideal response?

Answer 1

It was clear to Markowitz that some kind of model of covariance structure was needed for the practical implementation of the theory to large portfolios. He did little more than point out the problem and suggest some possible models of covariance. One model Markowitz proposed to explain the correlation structure among security returns assumed that the return on a security depends on an "underlying factor, the general prosperity of the market as expressed by some index."We might say that the purpose of Sharpe's development of the single index market model was in response to Markowitz's proposal. Thus, in response, Sharpe developed a model in 1963 where he tested the suggestion made by Markowitz through an examination of how stock returns tend to go up and down together with a general stock market index. Specifically, Sharpe estimated the relationship between the return on the market index (the explanatory variable) and the return on the stock (the dependent variable). The regression model Sharpe estimated is referred to as the single index market model or simply the market model. The regression coefficient of the market model that is estimated is referred to as beta and is a measure of the sensitivity of a stock to general movements in the market index.