Executive Summary Stock markets are quite dynamic and it offers several assets in various formats which are

grounds for investing money and gaining returns after specific time pe riods. Investors invest money to obtain highest return at lowest risk. So, profi tability and risk analysis is of utmost importance in todays world. The following work uses Treynors ratio (i.e. excess return to beta) as the criteria for the se lection of a stock in a portfolio. The algorithm gives the percentage weights to be invested in each stock selected without short selling, for an optimum portfo lio by evaluating the historical data available on stocks. Introduction: Modern portfolio theory (MPT) attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given lev el of expected return, by carefully choosing the proportions of various assets. The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is im portant to consider how each asset changes in price relative to how every other asset in the portfolio changes in price. Therefore, MPT is a form of diversification. Under certain assumptions and for s pecific quantitative definitions of risk and return, MPT explains how to find th e best possible diversification strategy. In this project, we make use of the Treynors ratio to find optimal allocation of funds to a portfolio of stocks. Capital Asset Pricing Model (CAPM) CAPM is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio , given that asset s non-diversifiable risk. The model takes into account the as set s sensitivity to non-diversifiable risk as well as the expected return of th e market and the expected return of a theoretical risk-free asset. The CAPM assumes that all investors: Aim to maximize economic utilities. Are rational and risk-averse. Are broadly diversified across a range of investments. Are price takers, i.e., they cannot influence prices. Can lend and borrow unlimited amounts under the risk free rate of intere st. Trade without transaction or taxation costs. Deal with securities that are all highly divisible into small parcels. Assume all information is available at the same time to all investors. Under these assumptions, the CAPM gives the equation: E(Ri) = Rf + i * (E(Rm) - Rf) ... (1) Where, E(Ri) is the expected return on the capital asset, Rf is the risk-free rate of interest such as interest arising from government bo nds, i is the sensitivity of the expected excess asset returns to the expected excess market returns, E(Rm) is the expected return of the market. Gauss Markov Theorem: In a linear regression model, Yt = + * Xt + t ... (2) Where, t is the stochastic disturbance term, satisfying the following assumptions : is normally distributed with mean zero and variance 2. X and are independent

Shocks are independent, The best linear unbiased estimate is given by the method of least squares. = Cov(X,Y) / Var (X) ... (3) This theorem can be applied on the CAPM equation to determine the beta of the st ock. Rewrite CAPM as, E(Ri) Rf = i * (E(Rm) - Rf) Thus, taking X = E(Rm) Rf, and Y = E(Ri) Rf, the beta of the stock can be obtain ed using Eq (3). Security Market Line (SML) The SML graphs the results from the capital asset pricing model (CAPM) formula. The relationship between and required return is plotted on the security market l ine (SML) which shows expected return as a function of . The intercept is the nom inal risk-free rate available for the market, while the slope is E(Rm) Rf. SML: E(Ri) = Rf + i * (E(Rm) - Rf) It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security s risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the i nvestor would be accepting a lower return for the amount of risk assumed. Treynors Ratio: Treynors ratio is a measurement of the returns earned in excess of that which cou ld have been earned on an investment that has no diversifiable risk per each uni t of market risk assumed. The Treynor ratio relates excess return over the risk-free rate to the additiona l risk taken; however, systematic risk is used instead of total risk. The higher the Treynors ratio, the better is the performance of the portfolio / security un der analysis. In our portfolio construction algorithm, the desirability of a stock is directly proportional to its Treynors ratio, given by: Treynors Ratio = (Ri Rf) / i ... () A higher Treynors ratio means that the stock is more undervalued. Hence, we calcu late the Treynors Ratio for all the stocks present in the market index (S&P CNX 5 00 in our case) and arrange them in descending order of Treynors Ratio. To determine which stocks should be included in our portfolio, we follow the pro cedure described in Elton et al []. A cut-point C* is determined and stocks with Treynors Ratio higher than this cut-point are included in the portfolio. To dete rmine C*, a Ci is calculated for each stock using: C_i= (_m^2 _(j=1)^i [{ (R _j- R_F )* _j }/(_( _j)^2 )] )/(1+ _m^2 _(j=1)^i (( Where, m = market volatility = unsystematic risk of stock j = beta value of stock j = return of stock j = risk free rate. Out of these Cis, there is only one Ci for which the Treynors ratio of all the sto cks preceding this ith stock is greater tha Ci and the Treynors ratio of all the stocks succeeding this ith stock is less than Ci. This Ci is the cut-point, i.e. C* and all the stocks preceding stock i are selected in our optimum portfolio.. X_i= Z_i/(Z_i ) Where, Z_i= _i/(_( _i)^2 ) [{((R_i- R_f ))/_i }- C^*] Implementation: We use the Prowess database for adjusted closing prices of the stocks present in S&P CNX 500 as well as that of the index itself. We have used the prices for pe riod of two years i.e. from 1-Apr-2010 to 31-Mar-2012. Calculate the daily return of all the stocks as well as market is calcul ated as

r(i) = [V(i+1)-V(i) ]/ V(i) Calculate the average daily return is calculated by using the geometric mean of the historical daily returns as given by: DR=((1+r1)(1+r2)(1+r3)(1+r4)(1+rn))1/n -1 Average annual return is calculated from average daily returns: AR = (1+DR)^252-1 Calculate the annual standard deviations from the daily standard deviations as Astd = 252 Dstd Calculate the raw beta using the Capital Asset Pricing Model for each st ock Ri(t) = Rf + i {Rm(t)-Rf} + i wh r Ri Rf = excess return of asset Rm- Rf = excess return of market i = shock factor with mean =0 Since beta is the slope of the above equation, we have used the SLOPE fu nction in excel to find the find the raw beta as per historical data. Geometric Mean of each stock is also calculated. Equation of SML is constructed using the equation: E(Ri) Rf = Beta(E(Rm)-Rf) Here, as per the rule, all stocks above SML are undervalued and below SM L are overvalued. One more logic which has been used is that if we put a point in an equat ion of a line (y-mx-c) and it comes out to be +ve, it means it lies above the li ne and if it is ve, it lies below the line. As per SML rule, all stocks which giv e (y-mx-c) as +ve are the stocks which we need to check. Here, y = Ri m = Slope x = Beta (Regression) c = intercept With 2 points on SML, (0, RFR) & (1, E(Rm)), we can get the slope and in tercept of above equation and hence, find values for all stocks. After filtering all positive value stocks, Treynors ratio is calculated u sing the below formula: Treynors ratio= (E[Ri] Rf )/i N xt, cut point for each shortlisted stock is calculated using the formu la: Ci = {Sigma(market)^2 *[Summation (j=1 to j=i) {E(Rj)-rf}Beta j]/Sigma(j)^2 }/ { 1+ Sigma(market)^2* Summation (j=1 to j=i)[Beta j^2/ Sigma(j)^2]} Sigma(market) = market volatility Sigma(j)^2 = unsystematic risk of stock (risk not related to market but stocks na ture) Beta j = beta value of the stock (index of systematic risk present in the jth st ock) E[Rj] = Expected return of jth stock

rf = risk free rate Next compare Cut point and Treynor ratio and include all those stocks in portfolio which has Ci> Treynors Ratio. This will give the final list of stocks which needs to be included in th e portfolio.

Result: Based upon the methodology, we get the below 13 stocks to be included in the por tfolio: Stock name Treynor ratio Amtek India Ltd. 0.005192198 Godrej Consumer Products Ltd. 0.004342676 Page Industries Ltd. 0.004083041 F A G Bearings India Ltd. 0.003575111 Eicher Motors Ltd. 0.003564797 Glaxosmithkline Consumer Healthcare Ltd. Supreme Industries Ltd. 0.003424438 V S T Industries Ltd. 0.003397712 Blue Dart Express Ltd. 0.003256848 Astrazeneca Pharma India Ltd. 0.003152084 Crisil Ltd. 0.002976685 Bosch Ltd. 0.002769614 Britannia Industries Ltd. 0.002742499

0.00350693