Construction of optimal portfolio using Single Index Model

The method used to construct the portfolio is derived from William Sharpes Single Index Model.

Markowitz laid the foundation for quantifying risk and his contribution is popularly known as Modern
Portfolio Theory. Markowitz model is used in selection of stocks based on risk and return analysis.
However, William Sharpe extended the work done by Markowitz.

Sharpe assumed that the return of a security is linearly related to a single index like the market index.

Casual observation of the stock prices over a period reveals that most of the stock prices move with the
market index. When the Sensex increases, stock prices also tend to increase and vice versa. This
indicates that some underlying factors affect the market index as well as the stock prices.

Therefore, stock prices are related to the market index and this relationship could be used to estimate
the return of stock.

Ri = i + i*Rm + ei

where Ri expected return on security i

i intercept of the straight line or alpha co-efficient

i slope of straight line or beta co-efficient

Rm the rate of return on market index

ei error term

He simplified the amount and type of data required to perform portfolio analysis. In Markowitz model,
number of co-variances have to be estimated. If a financial institution buys 150 stocks, it must estimate
11,175 i.e., (N2 N)/2 correlation co-efficient.

Sharpe made the numerous and complex computations easy which are essential to attain optimal
portfolio.

Sharpe justified that portfolio risk is to be identified with respect to their return co-movement with the
market and not necessarily with respect to within the security co-movement in a portfolio. Sharpe
therefore concluded that the desirability of a security for its inclusion is directly related to its excess
return to beta ratio.

Excess return to beta = (Ri - Rf) / i (where Rf is the risk free rate)

The steps for finding out the stocks to be included in the optimal portfolio are as follows:

Step 1: Find out the excess return to beta ratio for each stock under consideration. The stocks are
arranged in descending order of the beta ratio. This ranking order gives the best securities that are to be
selected for the portfolio.
Step 2: Proceed to calculate Ci for all the stocks according to the ranked order using the following
formula

Note: 2m = market variance, 2ei= Unsystematic risk

(Total risk= Systematic risk + Unsystematic risk i.e. 2i = i2 * 2m + 2ei)

Cut-off rate: The cumulated values of Ci start declining after a particular Ci and that point is taken as the
cut-off point and that stock ratio is the cut-off ratio C*.

Step 3: The highest Ci value is taken as the cut-off point i.e C*. The stocks ranked above C* have high
excess returns to beta than the cut off Ci and all the stocks ranked below C* have low excess return to
beta. So only the stocks where excess return to beta is more than or equal to cut-off value are
considered for preparing the portfolio.

Step 4: After determining the securities to be selected, we should find out how much should be invested
in each security. The percentage of funds to be invested in each security can be estimated as follows.

First a value Zi is calculated for each of the security shortlisted for the portfolio

Zi = (i / 2ei ) x [ (Ri Rf / i) C* ]

Then, Weight of each stock in the portfolio is determined by the formula Wi = Zi / (Zi)

Exercise (Please refer to the attached excel sheet)

Objective:

We have attempted to create an optimal portfolio from the pool of 30 stocks which forms the BSE
Sensex.

Assumptions:

We have considered previous 5-year daily stock price data to calculate the return, standard deviation,
variance, beta for these 30 stocks.

The risk-free rate of return is 6.5%

Solution:

We have used the Sharpes single index model method to calculate the optimal portfolio.

Result:
The shortlisted stocks along with their respective weights are given below:

Stocks Weights
Maruti Suzuki 58.24%
HUL 15.11%
Adani Ports 5.45%
TCS 5.45%
HDFC Bank 15.74%

Appendix:

The attached excel contains three sheets.

1) Data Contains 5 yr daily prices of 30 stocks in Sensex and the Sensex index.
2) Analysis Contains calculation of daily returns of all the stocks, calculation of standard
deviation, variation, Beta, Systematic risk, Unsystematic Risk.
3) Portfolio_Stocks Calculation of cut-off C, identification of the stocks in portfolio an their
respective weights.