MARKOWITZ PORTFOLIO OPTIMISATION PROCESS WITH SINGLE INDEX MODEL

Submitted to Prof. L.V.Ramana in partial fulfillment of requirements of QFFM Course

Group 5, Sec A
2012PGP141 2012PGP149 2012FPM020 2012PGP238 2012PGP007 Jagadeesh Putta Deepti Kalikavaya Vinod Kumar Rekhit Pachanekar Abhinav Mohan Singh

TABLE OF CONTENTS MARKOWITZ PORTFOLIO THEORY ....................................................................... 2

THE EFFICIENT FRONTIER .................................................................................................................. 2 THEORETICAL FRAMEWORK OF MARKOWITZ MODEL ................................................... 3

SINGLE INDEX MODEL .................................................................................................. 3 ASSUMPTION BEHIND SINGLE INDEX MODEL.................................................. 4 OBJECTIVE: ........................................................................................................................ 4 RESEARCH METHODOLOGY ...................................................................................... 5 FINDINGS AND ANALYSIS ............................................................................................ 5
COVARIANCE ESTIMATION ............................................................................................................... 6 OPTIMUM RETURN ESTIMATION ................................................................................................... 6

COMMENTs ON ASSUMPTIONS: ................................................................................ 7 CONCLUSION ..................................................................................................................... 8 LIMITATIONS AND FURTHER STUDY .................................................................... 9 APPENDIX: ........................................................................................................................ 10
CALCULATION SUMMARY...............................................................................................................10 STOCKS OF RANDOM PORTFOLIOS ...................................................................................................11

REFERENCES ................................................................................................................... 12

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

MARKOWITZ PORTFOLIO THEORY Harry Markowitz has developed portfolio model of investment. The model includes expected return, as well as the level of risk related to the return. Markowitz made following assumption on individual's investment behavior to develop his model: 1) An investor chooses the investment with lowest amount of risk if return is equal among given alternatives. 2) An Investors measure the risk on investment in terms of standard deviation or variance on asset return. 3) For each investment, investor can measure investment's expected return & probability of the returns over the time horizon specified. 4) Investors always seek to maximize its utility of investment return. 5) Investors decision is based on risk and return of investment, therefore, investor's utility curve of investor is based on risk & return. In Markowitz' theory, risk of a portfolio considers each investment's risk & return along with investment's correlation with other investments in portfolio. THE EFFICIENT FRONTIER Under Markowitz model a portfolio is considered efficient if it gives the investor a higher expected return with the same or lower level of risk as compared to another investment. The efficient frontier is thus a plot of those efficient portfolios,.

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

The optimal portfolio for any investor is the point on efficient frontier which is tangential to highest indifference curve for investor. However, considering that universe of assets in the world market is very big and so constructing efficient frontier and finding the optimum portfolio is very big problem. The no. of inputs required for MARKOWITZ Model increase very fast with increasing no. of assets under consideration. THEORETICAL FRAMEWORK OF MARKOWITZ MODEL The Markowitz model is used in selection of optimal portfolio Inputs: Ri = return on stock i K = maximum risk factor Covij= covariance between stock i and j N = portfolio size Decision Variables: Xi= fraction of portfolio to invest in stock i Objective: Maximize total returns: Constraints: Budget constraint: These inputs require estimates of the expected return on each stock ri and the possible covariance between each possible pair of stock, i.e. n estimates of returns, n estimates of variance and n(n-1)/2 estimates of covariance. So the estimation can get very complex as the portfolio size becomes large. For instance, if the number of stocks in a portfolio are 45, we need to estimate 45(44)/2 = 990 correlation coefficients. For this, Single index model was applied to provide the inputs to the Markowitz model.

SINGLE INDEX MODEL As we discussed, one of the main components in the inputs to portfolio analysis is the correlation structure of the stocks. When the number of stocks to select from the portfolio is large, the estimation of variation can get very complex for computational purposes. Single index model assumes that co- movement between QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL 3

stocks is due to the single common influence of market performance. The index model is based on the following assumptions: i. Most stocks have a positive covariance because they all respond similarly to macroeconomic factors. ii. However, some firms are more sensitive to these factors than others, and this firm-specific variance is typically denoted by its beta (), which measures its variance compared to the market for one or more economic factors. iii. Covariances among securities result from differing responses to macroeconomic factors. Hence, the covariance of each stock can be found by multiplying their betas and the market variance: The formulation of single index model can be as follows: i. ii. iii. Mean return of the stock: Variance of the stocks return, Covariance of returns between stocks:

Where beta is constant that measures the expected change in ri given a change in rm The single index model will need the estimates of mean return, variance of return and beta for each stock, which amounts to 3N+2 in comparison to N*(N+3)/2 in Markowitz model (e.g. 3* 45+2= 137 inputs in SI Model, in case of 45 stocks as compared to 990 inputs in normal model). For the purpose of Markowitz model, the mean Return of each stock and the variance of market returns are calculated. Finally, beta estimation is done for each stock to calculate the covariance needed in the Markowitz model. ASSUMPTION BEHIND SINGLE INDEX MODEL 1. Stock Returns are driven by a single factor that is market index return. 2. E(ei)= 0 for all i =1, 2, 3 3. Index unrelated to unique return; i.e. E[ei(Rm-E(Rm)]=04. E(eiej)= 0 for all I, j =1, 2, 3 ij for all i=1, 2, 3

OBJECTIVE: The SI Model, though insist that all stock returns are driven by market returns but, apart from the fact that it doesnt define what the market should be, it doesnt QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL 4

prove why stock market return should be explained by market return. Therefore, it is a question whether input provided by Single Index model provide good estimate for Markowitz Model. The objective of this study is to test whether inputs provided by single index model gives good estimates for the Markowitz Model. The objective is thus to gain insights on how to develop an effective computational procedure to determine optimal portfolios. RESEARCH METHODOLOGY To test whether SI Model correct input for the Markowitz model, we have made 15 portfolios and tested them for 3 different periods 2007-2009; 2009-2011; 2011-13. Stocks were mostly selected Randomly from various indices, including sector indices, from Indian stock market to make sure data availability and liquidity. We have taken weekly stock price data for 2 years for estimating Beta of the stock. Return on BSE Index has taken as return on market. The risk free rate is taken from RBI database for auction of government security. We have taken average of different rates on government securities for each year, then geometric mean of the two year return related to the corresponding period of analysis. Beta & standard error were estimated using regression between weekly stock return and weekly market return. We calculated covariance from stock weekly return data and then again estimated the covariance using SI Model. Optimization of portfolio was done by maximizing Sharpe ratio and covariance and optimum expected return for each portfolio with estimated data was calculated. A pair wise T-Test was then run on such obtained data on covariance & optimum expected return for Markowitz Mean-Covariance model, first by calculating covariance directly and again calculating covariance from estimates by using SI Model to see whether the two methods gives significantly different results or not. Null hypothesis for the test was that difference of mean value is zero. H0: Difference of mean = 0 H1: Difference of mean 0

FINDINGS AND ANALYSIS

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

COVARIANCE ESTIMATION The finding of Paired T-Test is produced below. The null hypothesis is rejected at even 1% significance level. Value of portfolio covariance as calculated under Markowitz model using all pair wise covariances and using SI Model are found significantly different. One tail test says that mean value of covariance under Single Index model is significantly high even at 1% confidence level, i.e. Single Index model estimates significantly higher covariance for Markowitz model. Portfolio Covariance t-Test: Paired Two Sample for Means of covariance estimate Markowitz Model SI Model Mean 0.112304 0.532515 Variance 0.003664 0.798716 Observations 45 45 Pearson Correlation 0.45469 Hypothesized Mean Difference 0 df 44 t Stat -3.24805 P(T<=t) one-tail 0.001114 t Critical one-tail 1.68023 P(T<=t) two-tail 0.002228 t Critical two-tail 2.015368 OPTIMUM RETURN ESTIMATION The paired T-Test for optimum return calculated under two techniques is produced below. P-value is found very high and so the null hypothesis is not rejected. The optimum return estimates from two models are not significantly different and can be concluded that both technique provides equal estimates, significantly not different. The finding doesnt seem in line with the first observation. It is because, while SI Model estimates higher covariance, it projects lower Sharpe-ratio, such that the expected return under both models becomes equal. Portfolio Optimum Return t-Test: Paired Two Sample for Means of optimum return estimate Markowitz Model SI Model Mean 0.444947 0.480207 Variance 0.294009 0.297717 Observations 45 45 Pearson Correlation 0.854004

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

Hypothesized Mean Difference df t Stat P(T<=t) one-tail t Critical one-tail P(T<=t) two-tail t Critical two-tail COMMENTs ON ASSUMPTIONS: The assumptions behind SI Model is that i. ii. iii. iv.

0 44 -0.80472 0.212655 1.68023 0.425311 2.015368

Stock Returns are driven by a single factor that is market index return. E(ei)= 0 for all i =1, 2, 3 E[ei(Rm-E(Rm)]=0- for all i=1, 2, E(eiej)= 0 for all I, j =1, 2, 3 ij holds

1. Assumption (2) & (3):

Out of these 4 assumptions, (2) & (3) are expected to hold because they are to hold by design. This actually found holding with the empirical data. For example, for portfolio (4), the result is produced below E(ei)= 0 0.0 0.0 00 00 00 00 0 0 for all i =1, 2, 3 0.0 0.0 0.0 0.0 00 00 00 00 00 00 00 00 0 0 0 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

E[ei(Rm-E(Rm)] 0.0 0.0 0.0 0.0 00 00 00 00 00 00 00 00 0 0 0 0

0.0 00 00 0

for all i =1, 2, 3 0.0 0.0 0.0 0.0 00 00 00 00 00 00 00 00 0 0 0 0

0.0 00 00 0

0.0 00 00 0

0.0 00 00 0

2. Assumption 1:

doesnt seems holding

The assumption that market movement explains alone the movement in stock return doesnt seem holding. For example for portfolio (4) as listed below, the variance in stock return is explained by about 20% on average and found as low as .42% to maximum 48.33%. Out of 15 stocks, R2 is 10% or less for 7 stocks, which shows that stock returns are not explained by a single index, i.e. stock market index. R2 in regression % term
3.46 34.36 9.17 6.76 0.42 19.35 48.33 26.62 10.23

(average= 20.50%)
33.61 19.43 0.44 18.85 35.00 41.50

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

This is very crucial finding on the most basic assumption, which raises question on using SI Model 3. Assumption 4: doesnt seems holding

This is another very crucial finding on the most basic assumption, which raises question on using SI Model. The assumption that expected value of covariance between the errors terms in any 2 stocks will be zero is not found hold in our calculation. i.e. E(eiej)= 0 for all I, j =1, 2, 3 (for ij) is not found true. e.g.

the E(eiej) calculation for the portfolio (4) is produced below.

eiej Matrix 1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 2 0.117 3 -0.015 0.099 4 0.028 0.183 -0.024 5 0.018 0.024 0.016 -0.026 6 -0.142 -0.048 -0.015 -0.012 0.141 7 0.039 0.251 0.079 0.061 -0.046 -0.099 8 -0.033 -0.012 -0.134 0.200 0.179 0.153 -0.177 9 0.195 0.168 0.118 0.136 -0.026 0.046 0.223 -0.163 10 0.082 0.242 0.185 0.009 -0.030 -0.247 0.224 -0.024 0.053 11 -0.147 0.131 0.204 0.045 0.051 -0.026 0.129 -0.119 0.039 0.157 12 0.147 0.223 0.080 -0.068 0.078 -0.087 0.015 -0.233 0.137 0.051 0.035 13 0.032 0.248 0.122 0.025 -0.051 -0.128 0.127 -0.198 0.060 0.322 0.225 0.219 14 0.009 0.322 0.306 0.016 -0.039 -0.195 0.238 -0.103 0.030 0.239 0.224 0.086 0.242 15 0.292 0.189 0.038 0.081 -0.064 -0.037 0.037 0.081 0.216 0.091 0.010 -0.038 -0.046 0.136

CONCLUSION From the analysis, it is found that inputs used using Single Index model doesnt provides the same estimates of input as Markowitz model for covariance, the two values are significantly different under 1% significance level for paired T-Test. The variance calculated by SI model is found significantly higher than Markowitz model. However, estimated optimum returns are not found significantly different, which is an inconsistency in the result. This is because the risk premium (Sharpe

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

ratio) per unit standard deviation in SI model is calculated very low, which is another inconsistency in the result. The major assumption behind SI model didnt found hold in our research. Neither the market index explains sufficiently higher portion of stock return variation, i.e., the basic claim of SI Model is not found correct. The covariances between error terms were also not found eliminated and they were different from zero, which again put serious question on correctness of calculation under SI Model. Because of these fundamental errors, the estimation and optimization using SI Model may lead to wrong portfolio creation and estimation of risk-return for portfolio, which may prove very costly to the investor as well as for the market. These inconstancies suggest that the use of multifactor model or some other models be explored for the portfolio optimization and risk-return estimation. The need to define market and market return is also very fundamental.

LIMITATIONS AND FURTHER STUDY The study was conducted with a limited set of data and limited period. The market in recent year, especially during the period of study has been very volatile that might have impacted market deviation from the assumptions of Markowitz and SI Models. As is found in beta estimates, the R2 of beta & estimate was very low showing that beta obtained through linear regression is a poor estimate and market index is explaining only a very small fraction of stock return. Market return during many periods have been even lower than risk free return while at the same time risk has been increased due to higher volatility resulting in negative Sharpe ratio for many portfolios which is contrary to theoretical framework and cant sustain in longer run. Selection of index as BSE also may be poor proxy for the market return as it only represents equity market. The equity market has performed very poorly and volatile during the period of study while many other asset classes have, like commodity, performed quite well. This indicates that BSE index might be a poor proxy for the market return and has affected estimation of beta as well. However, in spite of such limitation, result shows encouraging finding. Further study may be taken with broader base and for longer duration and better estimation technique. The result also suggests testing empirically any future new model or theory before proposing.

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

APPENDIX: CALCULATION SUMMARY For optimum Sharpe Ratio (SR) Covariance Calculation Markowitz optimised return With normal With normal With SI model With SI model covariance matrix covariance matrix 5.83% 0.96% 15.56% 11.26% 18.46% 24.52% 58.39% 59.17% 8.10% 2.86% 27.28% 16.27% 4.90% 1.14% 15.30% 11.57% 17.43% 41.76% 74.69% 79.05% 8.89% 2.95% 27.93% 16.40% 5.10% 0.92% 14.94% 11.18% 12.83% 43.11% 60.73% 80.78% 9.63% 1.58% 22.68% 14.24% 6.13% 18.60% 12.21% 12.22% 20.71% 59.65% 160.82% 125.09% 19.23% 554.02% 45.84% 98.27% 5.77% 14.68% 11.92% 11.72% 16.08% 73.68% 140.96% 138.60% 12.25% 43.43% 34.50% 34.47% 5.72% 12.61% 11.77% 11.44% 22.85% 89.74% 192.24% 152.21% 15.46% 36.56% 37.17% 32.29% 3.59% 2.10% 7.88% 6.22% 7.21% 32.44% 11.78% 14.36% 11.30% 5.64% 15.81% 11.09% 11.12% 42.12% 15.05% 16.71% 8.78% 26.28% 12.58% 13.29% 8.89% 8.41% 14.56% 12.55% 11.34% 60.26% 17.55% 20.09% 6.36% 35.36% 10.79% 13.61% 7.00% 7.38% 13.17% 12.42% 3.31% 63.06% 2.76% 39.64% 4.01% 44.26% -22.22% 107.16% 2.85% 1.92% 7.98% 8.04% 22.10% 34.36% 42.09% 31.38% 22.22% 76.76% 174.13% 138.25% 6.04% 17.10% 12.06% 12.05% 12.30% 106.38% 34.52% 49.16% 18.96% 270.94% 163.73% 254.34% 5.84% 17.89% 12.03% 12.15%

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

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12.71% 15.81% 8.18% 13.35% 24.11% 5.79% 15.26% 16.22% 5.35%

91.12% 33.79% 13.98% 88.92% 84.57% 38.14% 68.91% 95.07% 6.33%

41.10% 52.68% 11.00% 35.34% 182.19% 11.98% 39.77% 108.78% 8.24%

43.73% 49.23% 9.64% 42.92% 128.59% 11.71% 35.13% 143.01% 8.22%

STOCKS OF RANDOM PORTFOLIOS

1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Hcltech Itc Ltd. Cairn Gail Grasim L&T Airtel M&M Maruti Ntpc Ongc Bhel Ranbaxy Tata Steel Ultratech 2 L&T Airtel M&M Maruti Ntpc Ongc Bhel Ranbaxy Tata Steel Ultratech Bpcl Dr. Reddy Hindalco Axis Bank Asian Paints 3 Cairn Gail Grasim L&T Airtel M&M Maruti Ntpc Ongc Bhel Ranbaxy Tata Steel Ultratech Bpcl Dr. Reddy 4 United Brew Karnataka Bank Quadrant Wyeth Fact Sunpharma LNT Itc Exide Essar Yuken Zodiac Mrpl Unitech Lic 5 SSeasagoa Financialtech Gail M&M Acc Piramal Ultratech Suzlon Ucobank Sail Lic Techm Kingfisher Kotakm LNT 6 Tcs Ultratech Hcc Bhel Hcl Reliancec Tatasteel Jaiprakash Rcommunication Asian Paints Sbi Hdfc Iocl Dfm Abc Bears 7 Asian Paints Tcs Sesa Goa Idbi Lupin Mphasis Relinfra Sail Sci Sun Tv Tatachem Tatamotors Titan Sun Pharma Welcorp

8 LITL India Hotels Infy Ioc Jsw Steel Gskcons L&T M&M Marico Mindtree Adani Ent Polaris Fin Tech

10 11 Acc Adani Enterprises Aditya Birla Nuvo Bata India Bpcl Brittania Cairn Cipla Allahabad Bank Ashok Leyland

12 Allahabad Bank Ashok Leyland Bharat Forge Crompton Greaves Idbi Indian Hotels Hexaware Tech Oracle Financials Sun Tv Tata Chem Unitech

13 HDFC Infosys Sbi Relcap Asianpaints Bergpaint Yes Bank Tata Steel Tatapow Icici Bhartiairtel Tata Motors

14 Tatapow Icici Bhartiairtel Tata Motors Ajanta Pharma Jppower Axis Bank Gitanjali Jetair Hul Mrf Lupin

15 Asianpaints Bergpaint Yes Bank Tata Steel Tata Motors Ajanta Pharma Jppower Axis Bank Mrf Lupin Cipla Mnm

Bharat Forge Crompton Greaves Havells Indian Hotels Idbi Hexaware Tech

Mrf Oracle Financials Punj Lyod Sun Tv Tech Mahindra Sail Tata Chem Unitech

Bharatiairtel Lichf Glaxo Godrej Grasim

Upl United Bank Of India Voltas Syndicate Bank

Hindalco Realiacne Capital Aurobindo PharmaUnited Bank Of India

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

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Ptc Reliance Yes Bank

Idea

Cesc Adani Enterprises

Voltas Ajanta Pharma Jppower Axis Bank

Cipla Jsw Steel Bhel

Bhel Jetair Relcap

Oracle Fin Aditya Birla Nuvo Hero Motors Crompton Greaves

Allahabad Bank Aurobindo Pharma Havells Cesc

REFERENCES 1. Simplifying the portfolio optimization process using SI model, Yansen Ali, 2008 2. www.moneycontrol.com

QFFM_GROUP 5_MARKOWITZ PROCESS WITH SI MODEL

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