has been defined in Chap- ter 9 in the context of the CAPM. The choice is deliberate, however. Our reasoning will be obvious shortly. III. Equilibrium In Capital Markets 10. Single−Index and Multifactor Models The McGraw−Hill Companies, 2001           CHAPTER 10 Single-Index and Multifactor Models 295     Let us denote excess returns over the risk-free rate by capital R and rewrite this equa- tion as Ri i iRM ei (10.3) We write the index model in terms of excess returns over rf rather than in terms of total re- turns because the level of the stock market return represents the state of the macro econ- omy only to the extent that it exceeds or falls short of the rate of return on risk-free T-bills. For example, in the 1950s, when T-bills were yielding only 1% or 2%, a return of 8% or 9% on the stock market would be considered good news. In contrast, in the early 1980s, when bills were yielding over 10%, that same 8% or 9% would signal disappointing macroeco- nomic news.4 Equation 10.3 says that each security has two sources of risk: market or systematic risk, attributable to its sensitivity to macroeconomic factors as reflected in RM, and firm-specific risk, as reflected in e. If we denote the variance of the excess return on the market, RM, as M, then we can break the variance of the rate of return on each stock into two components:     Symbol   1. The variance attributable to the uncertainty of the common macroeconomic factor 2 2 i M 2. The variance attributable to firm-specific uncertainty 2(ei)     The covariance between RM and ei is zero because ei is defined as firm specific, that is, in- dependent of movements in the market. Hence the variance of the rate of return on security i equals the sum of the variances due to the common and the firm-specific