The Dual Index Model That Astutely Augurs Stock Prices Using Sectoral Indices An Empirical Evaluation of Securities That Are Not Constituents of India's Premier Stock Exchange Index Namely BSE-Sensex

Abstract

The concept of Single index model for pricing of assets had been widely used as a simple tool for forecasting returns of individual securities in tune with the movements of a general market index. The Capital Asset Pricing Model, a footing based on the fact that the alpha component and the residual risk tends toward zero as the number of securities are increased, reduces the single-index model equation to the market return multiplied by the risky portfolio's beta. The fundamental analysis and technical analysis have been the pillar stones on which asset pricing was built. However, no attempts have been made so far to connect technicals to fundamentals of a security. With single index model and multi factor model at the two extremes, an intermediate model, that augments the technicals of a stock to its fundamentals, is the critical idea postulated, to predict future prices. The model referred to Dual Index Model, empirically tests the security returns of two securities that are not constituents of general market index of India's premier stock exchange, the Bombay Stock Exchange, namely BSE-Sensex The dual index model, proposed in this paper, attempts to augment fundamental factors affecting security prices, such as company, industry and economy factors into the technical framework of regressing excess return on individual security with the fundamentals as regressors. While the company factors are decomposed into the expected excess return of the individual stock due to firm-specific factors that are commonly denoted by its alpha coefficient (α) or intercept or predictor constant, the industry factors and economic factors represented by excess returns on sectoral index and market index respectively are assumed to additional predictors in the multi regression, where the excess returns on security returns is the dependent variable. The effectiveness of the dual index model in precisely predicting returns, in the case of securities that are not constituents of the market index, is brought under the scanner and it has been conclusively evidenced that when sectoral index and market index are not highly correlated the dual index model is much superior to single index model in forecasting returns, be it forecast for a short period or long.