SHARPE INDEX MODEL

The investor always likes to purchase a combination of stocks that provides the highest return and has lowest risk. He want to maintain a satisfactory reward to risk ratio. Now a days risk has received increased attention and analysts are providing estimates of risk as well as return. the Markowitz model is adequate and conceptually sound in analyzing the risk and return of the portfolio. The problem with Markowitz model is that a number of co-variances have to be estimated. If the financial institution buys 150 stocks, it has to estimate 11175 (N2-N)/2 correlation co-efficient. Sharpe has developed a simplified model to analysis the portfolio. He assumed that the return of a security is linearly related to a single index like the market index.

SHARPE INDEX MODEL

SINGLE INDEX MODEL casual observation of the stock prices over a period of time reveals that most of the stock prices move with the market index. When the sensex stock prices also tend to increase and vice-versa. This indications that some underlying factors affect the market index as well as the stock prices are related to the market index and this relationship could be used to estimate the return on stock. Ri = a i + B i Rm + e i Ri ai Bi ei Rm = Expected return in security i = Intercept of the straight line or alpha co-efficient = Slop of straight line or beta co-efficient = Error term = The rate of return on market index

SHARPE INDEX MODEL

According to the equation, the return of a stock can be dividend into two components, the return due to the market and the return independent of the market. Bi indicates the sensitiveness of the stock return to the changes in the market return. The single index model is based on the assumption that stocks vary together because of the common movement in the stock market and there are no effects beyond the market ( fundamental factor effects ) that account the stocks co-movement. The expected return, standard deviation and co-variance of the single index model represent the joint movement of securities. The variance of securitys return has two components namely systematic risk or market risk and unsystematic risk or unique risk, The variance explained by the index is referred to systematic risk. The unexplained variance is called residual variance or unsystematic risk.

SHARPE INDEX MODEL

Systematic Risk = B2i * Variance of market index = B2i 62 m Unsystematic Risk = Total Variance Systematic Ris e2i = 62i systematic risk SHARPE OPTIMAL PORTFOLIO Sharpe had provided a model for the selection of appropriate securities in a portfolio. The selection of any stock is directly related to its excess return-beta ratio

Ri Rf
Bi The excess return is the difference between the expected return on the stock and the risk less rate of interest such as the rate offered on the Government security or treasury bill. The excess return to beta ratio

SHARPE INDEX MODEL

Measures the additional return on a security (excess of the risk less asset Return) per unit of systematic risk or non diversifiable risk. This ratio Provides a relationship between potential risk and rewards. Ranking of the stocks are done on the basis of their excess return to beta Portfolio managers would like to include stocks with higher ratios. The Selection of the stocks depends on a unique cut-off rate such that all Stocks with higher ratios of Ri - Rf / Bi are included and the stocks with Lower ratios are left off. The cut-off point is denoted by c* STEPS FOR FINDING OUT THE STOCKS TO BE INCULDED IN THE OPTIMAL PORTFOLIO : 1. Find out the excess return to beta ratio for each stock under consideration. 2. Rank them from the highest to the lowest 3. Proceed to calculate ci for all the stocks according to the ranked order.

SHARPE INDEX MODEL

62 N (Ri Rf ) Bi m ci

E
i=1

62 ei N B2i

1+ 62 m E 6 2 i=1 ei 6 2m = variance of the market index 62ei = variance of a stocks movement that is not associated with the movement of market index. 4. The cumulated valued of C start declining after a particular Ci and that point is taken as the cut off point and that stocks ratio is the cut off ratio C

SHARPE INDEX MODEL

Ci can be mathematically equivalent way Ci = Bip ( Rp Rf ) Bi

Bip = the expected change in the rate of return on stock I associated with 1 per cant change in the return on the optimal portfolio. Rp = the expected return on the optimal portfolio Bip and Rp can not be determined until the optimal portfolio is found. To find out the optimal portfolio the formula given previously should be Used. Securities are added to the portfolio as long as Ri Rf Bi Less than Ci

DATA FOR FINDING OUT THE OPTIMAL PORTFOLIO

Security Number 1 2 3 4 5 6 7 Mean Return 19 23 11 25 13 9 14 Excess Return 14 18 6 20 8 4 9 Beta Unsystematic Risk 1.0 1.5 0.5 2.0 1.0 0.5 1.5 20 30 10 40 20 50 30 Excess Return to Beta 14 12 12 10 8 8 6

DATA FOR FINDING OUT THE OPTIMAL PORTFOLIO

Security Number 1 1 2 3 4 5 6 7 Ri-Rf / Bi Ri-Rf * Bi / En (Ri-Rf)* Bi/ Bi2/ 62ei 62ei 2 62ei 3 5 4 14 12 12 10 8 8 6 0.7 0.9 0.3 1.0 0.4 0.04 0.45 0.7 1.6 1.9 2.9 3.3 3.34 3.79 0.05 0.075 0.025 0.1 0.05 0.005 0.075 En Bi2/ 62ei 6 0.05 0.125 0.15 0.25 0.30 0.305 0.38 Ci 7 4.67 7.11 7.60 8.29 8.25 8.25 7.90