PSG INSTITUTE OF MANAGEMENT Peelamedu, Coimbatore

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

MINI PROJECT REPORT ON
CONSTRUCTION OF OPTIMUM PORTFOLIO USING
SHARPE INDEX MODEL FOR LARGE, MID AND SMALL
CAPITAL COMPANIES

SUBMITTED TO:

DR. P. VARADHARAJAN MBA, PH.D.,

(Assistant Professor -Finance)
PSG INSTITUTE OF MANAGEMENT

SUBMITTED BY:

ASHOK KUMAR B T
MBA FINANCE

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CONSTRUCTION OF OPTIMUM PORTFOLIO USING

SHARPE INDEX MODEL FOR LARGE, MID AND SMALL
CAPITAL COMPANIES
Abstract
Indian securities market is a highly volatile and sensitive market where portfolio
construction is highly important to get good returns. The main focus of this research is to
construct an optimal portfolio in Indian Secondary market with the help of the Sharpe single
index model. Portfolio construction is an essential process of the investors for investment in
the equity market. A best combination of portfolio will effect in maximum return for a
particular level of risk. In this article, 20 selected stocks from large cap companies, mid-cap
companies and Small cap companies have been taken into consideration and these stocks are
member of the NSE Nifty index. The daily data for all the stocks for the period of September
2011 to August 2014 have been considered. The proposed method formulates a unique cut
off point (Cut off rate of return) and selects stocks having excess of their expected return
over risk free rate of return surpassing this cut-off point. Percentage of investment in each of
selected stocks is then decided on the basis of respective weights assigned to each stock
depending on respective beta value, stock movement variance unsystematic risk, and return
on stock and risk free return according to the cut off rate of return.
Keywords: Risk, Return, Beta, Portfolio, Residual Variance, Sharpe index and Index.

INTRODUCTION
Investing in more than one security has always been a subject of discussion in portfolio
management which includes the evaluation of a security to be finally included in an
optimum portfolio and to know as to how many securities ideally be included to form an
optimum portfolio. The developments to this regard started by Markowitz in 1952 by
propounding mean variance theory where an investor makes his decision based on the
expected return and the standard deviation of their overall portfolio.
Sharpe (1966) contributed Reward to Variability ratio (RVAR) which considers portfolio
performance as the ratio of excess portfolio return to the standard deviation, considering
total risk as the major concern while evaluating portfolio performance. Treynor (1965)
distinguished between total risk and systematic risk, implicitly assuming that portfolios are
well diversified, hence ignored unsystematic risk in his measure. He presented Reward to
Volatility ratio (RVOL) which is the ratio of excess portfolio return to beta.
William Sharpe (1964) has given model known as Sharpe Single Index Model which laid
down some steps that are required for construction of optimal portfolios. Stucchi (2006),
Smith (1969), Bansal and Gupta (2000), Singh (2007), Elton et al (1976) and Cristian (2006)
in their studies tested the efficiency of Sharpe Single Index Model to make optimum
portfolio selection. Their results are similar as all concluded that Single index model is
efficient in constructing optimal portfolio and portfolio return is much higher than the
portfolio variance. Paudel and Koirala (2006) checked the efficiency of Sharpe portfolio

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optimization model in Nepalese Stock market and identified that portfolio beta is
significantly lower than the market beta.
William F. Sharpe got the Nobel Prize in 1990, shared with Markowitz and Miller, for such
a seminal contribution in the field of investment finance in Economics (Brigham and
Ehrhardt, 2002). Sharpes Single Index Model is very useful to construct an optimal
portfolio by analyzing how and why securities are included in an optimal portfolio, with
their respective weights calculated on the basis of some important variables under
consideration.

PROBLEM STATEMENT
Investing in individual securities is associated with high risk. Many investors are not able to
choose the best portfolio for investment. As Stock market has both high return and high risk,
investors should be aware about their investment decision. Not many people invest in stock
market and the level of awareness among Indians about stock market is less. Also, holding
two or three stocks is always better than holding one.

OBJECTIVE OF THE STUDY

PRIMARY OBJECTIVES
To construct an optimum portfolio of securities from the selected 20 companies in
Large, Medium and Small market capitalization categories using Sharpes Single
Index Model, which minimize the risk and maximize the return.
SECONDARY OBJECTIVES

The stock price movements, closing index points of the companies and beta values for
the past four years are collected for analysis
To find the movement of share prices, expected returns.
To calculate market variance, individual stock variance, standard deviation and beta
values.
To find the proportion of money to be invested in each of these companies.

SCOPE OF THE STUDY

Scope of the study is to construct the optimum portfolio in Large, Mid and small market
capitalization companies to reduce its risk and maximize the profits. Based on the historical
performance, risk and return of those companies should be analyzed and top companies
should be selected for construction of portfolio.

LIMITATIONS OF THE STUDY

Portfolio is constructed based only on risk and return.

Stock prices considered only for 3 years so that the real impact cannot be found.
All the calculations could not be brought into the report.
This research should not be suitable for short-term investment.

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LITERATURE REVIEW
Varadharajan P and Ganesh (2012), explained the applications of the Sharpe rule in portfolio
measurement and management. It proposes that a portion of the portfolio value should be
invested in some other assets for portfolio improvement. With the help of Sharpe rule they
determined that the new stocks are worthy of adding to the old portfolio whether they satisfy
a condition. Dr. Sathya Swaroop Debasish and Jakki Samir Khan (2012), stated a good
combination of portfolio will give maximum return for a particular level of risk. Ebner and
Neumann (2008), explained the correlation instabilities in US stock returns and used three
different estimation approaches to overcome the problem : (1) moving window least squares,
(2) flexible least squares and (3) the random walk model. The results suggest that a
timevarying estimation of return correlations fits the data considerably better than time
invariant estimation and thus, increases the efficiency of risk estimation and portfolio
selection. Varadharajan (2011) constructed an optimal equity portfolio with the help of
Sharpe Index model. The portfolio predominantly consisted of stocks from the banking
sector, and one stock from IT sector to maximize the portfolio return. Naveen Ch. (2014)
stated an attempt has been made to test the validity of the Sharpe model to construct the
portfolio. Sharpe in his single index model formulates a unique cut off point (cut off rate of
return) to select the qualified securities to construct optimal portfolio. According to him
Securities with highest Excess return to Beta value than this cut off point are eligible. Rachel
Campbell (2001), stated about optimal portfolio selection is that a portfolio selections a
model which allocates financial assets/ securities by maximizing expected return based on
the constraint that the expected maximum loss should meet the Value-at-Risk limits set by
the risk/fund manager. Mokta Rani Sarker (2013) stated Sharpe index method formulates a
unique cut off point and selects stocks having excess return to beta ratio beyond this cut off
point, and determines the percentage of investment in each of selected stock. Hiroshi Konno
and Hiroaki Yamazaki (1919), explained that a portfolio optimization model using mean
absolute deviation risk function can remove most of the difficulties associated with the
classical Markowitz while maintaining its advantages over equilibrium models. Nithya J
(2014) explained closing price changes the trend and time of entry and exit in the market can
be predicted and fund allocation for each script can be analyzed by the way using Sharpe
(single index model) method. Kapil Sen and Disha CA Fattawat (2014) stated that optimal
portfolio selection using Sharpe Single Index model, through which a remarkable reduction
in the riskiness or variability of the return of securities can be obtained. Ward, David J
Griepentrog, Gary L (1993), explained how well an investor should invest mainly focusing
on investment in defaulted bonds and how appropriately they should be diversified to earn
higher rate of expected returns. Such kind of a portfolio attracts investors by giving higher
returns but on the contrary will also increase the level of unsystematic risk. Hence, investors
have to examine the risk and return factors carefully, as they offer higher returns than
equities and normal bonds. Sandeep Bansal, Sanjeev Kumar And Surender Kumar Gupta
(2012) stated the slow growth of Indian capital market and private participation in the Indian
mutual fund industry, the challenge to survive and retain investor confidence has been a
prime area of concern for mutual fund managers and researchers and selected outperforming
and underperforming schemes by the way using Shape index model. Rudin, Alexander M;
Morgan, Jonathan S,(2006), stated the importance of diversification in portfolio construction,
our current methods of measuring it are inefficient. Implementation in hedge fund strategies
reveals that various hedge funds offer less diversification than may have been thought, and
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that there has been reduced diversification in the past several years. YASH PAL TANEJA
and SHIPRA BANSAL (2011) explained diversification across asset classes provides a
soften solution against market because each asset class has different risk and rewards to
economic events. Therefore, it becomes obligatory to drill down the evaluation to the level
of individual securities to ascertain whether the security is an admissible security in terms of
investment policy and to see whether it has added value to the portfolio. Niranjan Mandal
(2013), stated that the Sharpe ratio can be calculated directly from the elasticity of the
stochastic discount factor with respect to consumption innovations as well as the volatility of
consumption innovations.

METHODOLOGY:
For constructing the portfolio in this project we have selected companies from three
sectors namely Large-cap, Mid-cap and Small-cap companies in NSE Listing. From each
sector companies are selected based on highly liquidation and most active securities.
This is a descriptive study in which statistical data is analyzed for construction. Data
collected from NSE India web portal for closing price of selected company shares and Nifty
value. Risk free rate (T-Bills) collected from Reserve Bank of India (RBI). The study is
conducted with the financial data for the past four years from September 2011 to August
2014. The sample size of the study is 22 and they are taken from two sectors namely Power
and Steel Industries. The sampling technique used here is random sampling.

STATISTICAL TOOLS USED

RETURN
The total gain or loss experienced on an investment over a given period of time,
calculated by dividing the assets cash distributions during the period, plus change in value,
by its beginning-of-period investment value is termed as return.
Return = ((Todays market price Yesterdays market price)/Yesterdays market price)*100

BETA COEFFICIENT
Beta coefficient is the relative measure of non-diversifiable risk. It is an index of the
degree of movement of an assets return in response to a change in the markets return.

Where, b = Beta x = stock return

= mean of stock return
Y = Nifty return
= mean of Nifty return

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RISK-FREE RATE OF RETURN (RF)

Risk-free rate of return is the required return on a risk free asset, typically a three
month treasury bill. (Current T-bill rate 8.65%)

EXCESS RETURN-BETA RATIO

It is the ratio of returns in excess of the risk-free rate.

Where, Ri= the expected return on stock i, Rf = the return on a riskless asset, = the
expected change in the rate of return on stock associated with one unit change
in the market return.

CUT-OFF POINT
This is the point at which an investor decides whether or not a particular security is worth
purchasing. The formula is given by Sharpe model as follows:

Where,

= variance of the market index

= Residual variance i.e. variance of a stocks movement that is not associated

with the movement of market index.

INVESTMENT TO BE MADE IN EACH SECURITY

Where,

And,
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= is the proportion of investment of each stock

Where,

= the cut-off point.(highest value of the Ci)

ANALYSIS AND DISCUSSIONS

The best model to measure the risk is Residual Variance and beta and using this stock
return is calculated.

Table 1.1: Return, Variation and Beta of Individual Stock

0.134839

Beta value

0.557522

Residual Variance
ei
2.715985

TATA MOTORS

0.092563

1.55077

14.39277

SUN TV

0.055097

0.887416

7.033215

SUN PHARMA

0.108105

0.538662

5.833132

SPARC

0.163777

0.670587

7.821989

RPOWER

0.015897

1.52237

6.544001

ORISSAMINE

-0.08401

1.108587

22.7898

NAUKRI

0.056121

0.262317

7.355406

MRF

0.186556

0.819664

3.59483

MARUTI

0.145892

0.830917

3.734419

LT

0.023426

1.342393

5.739821

LAKSHVILAS

-0.00637

0.766644

5.77881

INFY

0.077678

0.644418

3.651979

IDFC

0.070273

1.676285

6.744081

GODREJIND

0.086915

1.074436

4.761549

GMRINFRA

0.040907

1.62431

10.11617

FORTIS

-0.01649

0.591761

3.011634

ESSAROIL

0.094687

1.22524

9.603662

ASIANPAINT

-0.02072

0.756739

13.42896

APOLLOTYRE

0.171577

0.946846

6.858298

Scrips

Mean Daily Return Ri

TCS

* Risk free rate 8.65% pa

* Risk free rate 0.0237% perday

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Table 1. 2: Excess return to beta ratio

Scrips

(Ri-Rf)/

Rank

New Ranking

TCS

0.199348

SPARC

TATA MOTORS

0.044406

11

TCS

SUN TV

0.035381

12

MRF

SUN PHARMA

0.156697

SUN PHARMA

SPARC

0.20889

APOLLOTYRE

RPOWER

-0.00512

16

MARUTI

ORISSAMINE

-0.09716

20

NAUKRI

NAUKRI

0.123599

INFY

MRF

0.198688

GODREJIND

MARUTI

0.147058

ESSAROIL

LT

-0.0002

15

TATA MOTORS

LAKSHVILAS

-0.03922

17

SUN TV

INFY

0.083765

IDFC

IDFC

0.027784

13

GMRINFRA

GODREJIND

0.058837

LT

GMRINFRA

0.010594

14

RPOWER

FORTIS

-0.06791

19

LAKSHVILAS

ESSAROIL

0.057938

10

ASIANPAINT

ASIANPAINT

-0.05869

18

FORTIS

APOLLOTYRE

0.15618

ORISSAMINE

Rf (8.65/365)

0.0237

SPARC (Sun Pharma Advance Research Center) yielded the maximum return among
the companies selected and Orissa Minerals Development Company yielded lower return
following that Asian Paint and Essar Oil Corporation yielded lower return. Small and Midcap have shown a higher return in all the companies chosen for the analysis. It shows that
Mid- cap securities are the growing sector and it is most preferred investable securities in
India. Beta is greater than 1 in Tata power, Reliance power, Larsen turbo , IDFC, Orissa
mine, GMR Infra, Godrej Industries and Essar Oil , which shows that these securities have
more risk and at the same time the reward per unit of risks is also more. But in case of other
companies with regards to beta it is less than 1 which shows it is less risky when compared
to market risk.
Sharpe has provided a model for the selection of appropriate securities in a portfolio.
The excess return of any stock is directly related to its excess return to beta ratio. It measures
the additional return on a security (excess of the risk less asset return) per unit of systematic
risk. The ratio provides a relationship between potential risk and reward. Ranking of the
stocks are done on the basis of their excess return to beta. Based on the excess return to beta
ratio the scrips are ranked from 1 to 20, with SPARC being in the first rank and Orissa
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Minerals being in the last. The excess return to beta ratio was calculated using 8.65% as risk
free rate of return.
Table 1:3: Cut-off point calculation for 20 companies
m((RiRf))/ei
Companies
(Ri-Rf)/
SPARC
0.2088899
0.0135957
TCS
0.1993477
0.0394242
MRF
0.1986883
0.0814637
SUN PHARMA
0.1566965
0.0902880
APOLLOTYRE
0.1561803
0.1134013
MARUTI
0.1470584
0.1441816
NAUKRI
0.1235992
0.1454906
INFY
0.0837652
0.1562742
GODREJIND
ESSAROIL
TATA MOTORS
SUN TV
IDFC
GMRINFRA
LT
RPOWER
LAKSHVILAS
ASIANPAINT
FORTIS
ORISSAMINE
m

0.0588371
0.0579381
0.0444065
0.0353815
0.0277841
0.0105942
-0.0002030
-0.0051247
-0.0392243
-0.0586911
-0.0679120
-0.0971628
1.1321181

0.1724236
0.1826768
0.1910770
0.1955620
0.2086678
0.2117959
0.2117237
0.2096690
0.2051526
0.2023191
0.1933793
0.1874475

1+m/ei
1.0650855
1.1946507
1.4062358
1.4625507
1.6105412
1.8198481
1.8304391
1.9591749

Ci
0.0127649
0.0330006
0.0579303
0.0617333
0.0704119
0.0792273
0.0794840
0.0797653

2.2336512
2.4106201
2.5997856
2.7265485
3.1982473
3.4935137
3.8489424
4.2498909
4.3650349
4.4133121
4.5449502
4.6060009

0.0771936
0.0757800
0.0734972
0.0717251
0.0652444
0.0606255
0.0550083
0.0493351
0.0469991
0.0458429
0.0425482
0.0406964

From the table 1.3. It seen that Excess return to Beta ratio values of the first 8
securities exceed the Ci values of the respective securities. The Ci value of the 8 the
securitys (INFOSYS) cut off value is highest value (C*=0.0797653) taken as the Cut-off
point that is C* below which excess to beta ratio is less than the respective Ci value of the
security and the collection of these top ten securities, having (Ri-Rf)/ >=C*, make it to the
optimal portfolio.

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PORTFOLIO INVESTMENT:
For determining the proportion of portfolio Zi value is calculated by,
Zi = /2ei ((Ri-Rf/ -C*))
Then Xi value is calculated as,
Xi = Zi / Zi

Table: 1:4: Proportion of Investment in each Stock

Companies
Xi
SPARC

11%

TCS

25%

MRF

28%

SUN PHARMA

7%

APOLLOTYRE

11%

MARUTI

15%

NAUKRI

2%

INFY

1%

Table 1.4 shows the proportion of investment in each stock. And it indicates the
weights on each security and they sum up to 100 percentage. By using Sharpe index model
thus we are able to find out the proportion of investments to be made for an optimal portfolio.
The maximum investment should be made in MRF with a proportion of 28%. Following that
TCS, Maruti, Sun Pharma Advance Research Center and Apollo Tyre are the next four
companies where major percentage of investment can be made. Evidently, the companies
chosen for the investments are growing at a steady rate in the recent years.

FINDINGS
The Large-cap and Mid-cap companies are the major contributors for the portfolio.
Among selected 20 companies (large, mid and small-cap) large cap and mid cap companies
performing than small cap companies.
Beta value for those stocks lesser than 1 which indicates minimal risk involved in
those stocks. Here the 8 stocks have lesser beta value than 1.

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RECOMMENDATIONS

The recommended proportion investments to the companies according to constructed

portfolio are MRF 28%, TCS 25%, Maruti 15%, Sun Pharma Advance Research
Center 11%, Apollo Tyre 11%, Sun Pharma 7% Naukri 2% and Infosysis 15.
Investors expecting high return for the minimal risk can go for TCS & Naukri (<1).
To investors who are risk takers can go for MRF & Maruti.
Investors better not to think about Laksmi vilas Bank, Asian Paints, Fortis Healthcare,
and Orissa mineral Development Company.

2%

1%
11%

15%

SPARC
Tcs

11%

25%

MRF
SUN PHARMA
APOLLOTYRE

7%

MARUTI
NAUKRI
INFY

28%

CONCLUSION
Though there 20 stocks that meet the criteria for being included in the Portfolio, the portfolio
is constructed with the top 8 stocks that meet the criteria to include in the portfolio by way of
Sharpe Index model. This stocks are: Sun Pharma Advance Research Center, TCS, MRF, Sun
Pharma, Apollo Tyre, Maruti, Naukri & Infosys. The portfolio predominantly consists of
stocks from Large Cap Companies 48% (TCS, Maruti, Sun Pharma), and mid-cap Companies

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is 39% (MRF & Apollo Tyre) and remain 13% Stocks from Small-cap companies (Sun
pharma advance Research Center, Naukri) of total investment.

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http://www.nseindia.com
http://www.moneycontrol.com
http://www.indiainfoline.com
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 http://www.rbi.org.in
http://www.screener.in/

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