Sharpe’s Portfolio Theory

As you saw in earlier classes that the Modern Portfolio Theory by Markowitz requires n
estimates of variances and n(n - 1)/2 estimates of unique covariances estimated as inputs to
calculate total risk of portfolio (VARp). Thus the theory required a large number of estimated
items; therefore computational requirements were daunting in 1950s when the theory was
presented by Markowitz. Sharpe simplified the formula of total risk of portfolio; and his
formula requires fewer estimated inputs for calculating total risk of portfolio. Let us
understand in some detail the simplification proposed by Sharpe to calculate total risk of
portfolio.

Sharpe proposed that ROR of any security (Ri) is sensitive to ROR of overall stock market (Rm)
in a linear fashion. Up till now we have looked at expected ROR of a stock as composed of 2
components, namely: expected capital gains yield plus expected dividend yield , i.e.:
Expected ROR of a stock = {(P1 – P0) / P0 } + DPS1/P0 . But Sharpe argued that historical data
has shown that as stock market’s ROR increases or decreases, RORs of most of the stocks also
increase and decrease; he further argued that this relationship is linear. If his assumption is
accepted then it follows that relationship of stock returns with the stock market returns can
be written as:

Ri = αi + βiRm + ei
Whereas:
Ri ……..is the dependant variable on y-axis, i.e. expected ROR of any stock.
αi ........intercept of a straight line with y-axis
βi ……. Slope of a straight line.
Rm…….independent variable on x-axis, i.e. expected ROR of the overall stock market.
ei……..random error term. Expected value (or mean) of error term is assumed to be zero, but
it does have a variance which is denoted as VARei (variance of error term of stock i)

For practical purposes Rm is estimated as %age change in a stock market index such as KSE-
100 index. Usually such change is estimated for a one year time period. Expected return of
stock market for the next year , expected Rm , can be estimated as:
Expected Rm = (expected KSE-100 Index end of the year – KSE-100 index now) /KSE-100 index now

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Sharpe also showed that, with some assumptions, total risk of a stock (VAR i) is:

VARi = βi2 VAR m + VAR ei

This is the expression by Sharpe for total risk of asingle stock. Note:
Ri = αi + βiRm + ei
represents a linear relationship between Ri and Rm . Such relationship when drawn on paper
appears as a straight line. Graph of historical returns of stock ‘i ’ and stock market is shown
below:

e 2005
e2003
e1998
Ri e2001 Characteristic Line for Stock ‘ i’
αi e1999
e2000 e2004

RM

The circles show actual RORs of stock i and stock market for that year; whereas the stright line
captioned as charecteristic line shows estimated Ri from the linear model given above.
Vertical distances shown by arrows are called error terms for those years such as ei 2001 , ei 2004.
These vertical distances between actaual ROR of stock i and estimated ROR of stock i from
the linear model are estimation error present in the linear mod as ei

Regression theory says that for a large data set the errors above the line (+ ive) would cancel
errors below the line (-ive), and therefore average error or expected value of error is zero. But
error term does have a variance called VARei.

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 Sharpe Simplification of Total Risk of Portfolio
With these assumptions, Sharpe simplified the Rp and VARp formulae as follows
We know that according to Markowitz, expected Rp = ∑XiRi
But according to Sharpe for each stock expected rate of return is Ri = α i + βiRm + ei
So inserting this expression of Ri in the Rp formula, we get
Rp = ∑Xi [α i + βiRm + ei] ; which can be written as:
Rp = ∑Xi αi + {∑Xi βi} Rm + ∑Xi ei
Rp = ap + βp * Rm + ep.
Note this is also a linear relationship. Where
ap = ∑Xi α i = X1 α 1 + X2 α 2 + ………………. + Xn α n . It is intercept of straight line with y-axis; and
it is weighted average of intercepts of the stocks included in that portfolio
βp = ∑Xi βi = X1β1 + X2β2 + ………………….. + Xnβn. It is slope of straight line; and it is weighted
average of the betas (slopes) of the stocks included in that portfolio.
ep = ∑Xi ei = X1e1 + X2e2 + ……………….. + Xn en . It is error term whose expected value (mean ep
) is zero by definition; but it does have a variance called VAR e p; and it is weighted average of
the error terms of stocks included I that portfolio

Sharpe also proved that covariance of returns of any 2 stocks (COV i,j ) is = βiβjVARm ; so if you
know beta of 2 stocks and VARm of stock market returns (total risk of market) then you can
calculate COV between returns of those 2 stocks.
As you know that Markowitz expression for total risk of portfolio is :
VARp = ∑Xi2 VARi + ∑∑ Xi Xj COV i,j (i≠j).
And Sharpe has given total risk of a stock as : VARi = βi2 VAR (m) + VAR (ei)
Putting this value of total risk of a stock in total risk of portfolio formula we get:
VARp = ∑Xi2 [βi2 VARm + VARei] + ∑∑ Xi Xj COV i, j (i≠j).
Since Sharpe also proved that COVi,j = βiβjVARm , therefore putting this expression of COV i,j in
VARp formula we get :
VARp = ∑Xi2 [βi2 VARm + VARei] + ∑∑ Xi Xj βiβj VARm . (i≠j).
Further opening it, the first term becomes (∑Xi2 βi2 )VARm + ∑Xi2 VARei , and it can also be
written as: ∑XiXi βiβi VARm + ∑Xi2VARei
if the condition stock’ i’ is not stock ’ j’ is removed , then the last term ∑∑ Xi Xj βiβj VARm can
also be written as :
∑XiXi βiβi VARm
which is exactly same as one of the expressions in the first term
This leads to interesting result:

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VARp = ∑XiXi βiβi VARm + ∑Xi2 VARei + ∑XiXi βiβi VARm ; and this can be written as
VARp = ∑ ∑ XiXi βiβi VARm + ∑Xi2 VARei , this can be written as
VARp = [(∑Xi βi ) (∑Xi βi )]VARm + ∑Xi2 VARei
since ∑ Xi βi is βp therefore; and ∑Xi2 VARei is called variance of error term of poirtfolio denoted
as VARep, therefore
VARp = ( βp * βp) VARm + VARep

VARp = βp2 VARm + VARep

This is the Formula of total risk of portfolio by Sharpe
Where:
βp = ∑ Xi βi = X1β1 + X2β2 + ………………….. + Xnβn
VAR (ep) = ∑ Xi2 VAR (ei) = X12 VAR (e1) + X22 VAR (e2) + .....+ Xn2 VAR (en). (1 to n are stocks)
So in conclussion:
Markowitz said: VARp = ∑ Xi2 VARi + ∑∑ Xi Xj COVi.j (i is not j)
But Sharpe said: VARp = βp2 VARm + VARep

The Concept of Beta of a Stock, βi

As the expression beta has appeared frequently in previous discussion, it is important to have
clear understanding about its various meanings.

Mathematically beta of a stock is a ratio: Beta of stock i is , βi = COV i,m / VARm ; and beta of
stock j is βj = COV j,m / VARm . Please note that COV i,m can be negative therefore beta of a
stock i can be negative, though such stocks are rare in actual life. Countercyclical stocks may
have negative correlation ( or covariance) of their reteurns with the returns of stock market
and therefore can have negative beta.
If beta is a ratio of covariance of an asset’s returns with market returns divided by variance of
market returns then it follows that if you take the whole stock market as a portfolio then
βm = COV m,m / VARm
But we know COV m,m = VARm . So
βm = VARm / VARm = 1.
This is a proof that beta of a stock market is always ONE for any stock market. Beta of
Pakistani market is 1, beta of Indian market is 1, beta of US market is 1 according to the
Sharpe’s formulation. Beta of 1 is considered average beta because beta of market is
weighted average of betas of all the stocks in that market.

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Geometrically beta of any stock (βi ) is the slope of straight line shown above where Rm is on
the horizontal axis and Ri is on the vertical axis, this line is termed characteristic line for that
stock; and it is drawn by using actually realized RORs of the past years for stock market and
RORs for that particular stock as inputs for the linear regression model shown above.
Regression procedure using the historical data of returns gives estimates of alpha and beta of
that particular stock. These are also called constants, or coefficients, or parameters of the
linear model. The characteristic line is drawn by inserting actual Rm of each past year along
with the alpha and beta given by regression into the linear model to get an estimate of Ri for
that year by using Ri = αi + βiRm ; and an estimate of Ri for each year is calculated. Then actual
Rm and estimated Ri are placed on graph paper to get dots; when these dots are connected
you get a straight line called the characteristic line of that stock as shown above.

You know that slope of any straight line is: rise / run; that is change in Ri for a unit change in
Rm , and therefore beta of a stock tells us that 1%age point change in Rm causes what %age
point change in ROR of that stock. For example if Rm changes from 14 to 16%, and
commensurate change in Ri is from 20 to 24% then on the graph shown above, the rise is 24 -
20 = 4%; and run is 16 -14 = 2%; and slope is : rise / run = 4% / 2% = 2, and you would conclude
that beta of that stock is 2. Please note that % signs cancel each other and the answer is not
2% but just 2. Alpha of linear model is in percentages but beta is just a number, it is not a
percentage.

Conceptually beta of any stock (βi ) is the sensitivity of returns of a stock to returns of stock
market. For example if Beta of ICI stock is 2, it means if Rm goes up by 1 %age point this year
compared to the last year then, ROR of ICI would go up 2 %age points this year compared to
its ROR last year.
For example suppose alpha of ICI is 1% and beta of ICI is 2; and last year ROR of stock market
was 10%, then you would estimate that expected ROR of ICI stock for last year was:
RICI = αICI + βICIRm
= 1 + 2* 10
= 21%
Now suppose this year estimate for Rm is 11% (that is 1 % age point increase in Rm compared
to last year’s Rm), so you would estimate ICI stock return for this year as:
RICI = αICI + βICIRm
= 1 + 2* 11
= 23%

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So we saw that 1%age point increase in Rm from 10% to 11% has caused 2%age point increase
in estimated RICI from 21% to 23%. It is so because ICI beta is 2.
As another example:
If αUBL was 3% and beta of UBL stock was 0.8, then last year’s estimated RUBL from linear model
proposed by Sharpe would have been:
RICI = αUBL + βUBLRm
= 3 + 0.8*10
= 11%
and this year’s estimated RUBL would have been
RICI = αUBL + βUBLRm
= 3 + 0.8*11
= 11.8%
i.e. a 1% age point rise in Rm from 10% to 11% would have caused 0.8%age point rise in returns
of UBL stock from 11% to 11.8%, and this would be so because beta of UBL stock is 0.8. The
bigger the beta of a company’s stock, more is sensitivity of its stock returns to changes in stock
market returns. That means a slight change in stock market ROR would cause a big change in
ROR of such a stock.

Please note that actual ROR of UBL would be found as capital gains yield plus dividends yield.
And then error term of UBL for the year would be calculated as:

e UBL = Actual ROR – estimated ROR from linear model.

And this error term may come out negative or positive for that year. For example actual ROR
of UBL stock last year was 13% and you estimated above from linear model 11% then eUBL for
the last year was : 13 % – 11% = 2%

In the context of portfolio theory, Sharpe designates beta of a stock as relevant risk of that
stock. It is a justified name for the beta of a stock because according to Sharpe total risk of
any stock is :
VARi = βi2 VAR m + VAR ei
In this expression VARm is total risk of stock market, and it is a given macro-economic fact and
therefore it is same for all stocks. Variance of error term of any stock (VAR ei ) is termed as
company specific risk of a stock; and it is assumed as diversifiable when a stock is mixed with
other stocks in the form of a portfolio. It is so because the impact of company specific good
event in one company may be cancelled out by company specific bad event in another
company when both stocks are in a portfolio; thus overall impact of company specific events

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on the total risk of portfolio may actually be very small, that is, VAR ep is likely to be small in a
well diversified portfolio. Later on you shall see that it is about 40 stocks that make your
portfolio almost well diversified by making VAR ep close to zero.

Therefore only thing relevant for making decision about total risk of a portfolio is beta of the
stocks included in the portfolio. If high beta stocks are chosen then resulting portfolio beta
would be high and consequently total risk of portfolio would be high; and if low beta stocks
are chosen the resulting portfolio beta would be low and consequently total risk of portfolio
would be low; while VARm (total risk of the stock market, also called Market Risk) would be
there as part of portfolio total risk no matter what portfolio you are considering to build, and
the VAR ep would be so small that it can be ignored. In this decision making context, beta of a
stock is the relevant risk of that stock as it has impact on the total risk of portfolio, while other
expressions appearing in above stated total risk formula of a stock are not relevant for decision
making, according to Sharpe. Because with VARm you have to live as long as you are
operating in Pakistani market and you cannot get rid of market risk, while impact of variances
of error terms of stocks included in your portfolio can be made to approach zero by building
well diversified portfolio.

Example of simplification of calculation of VARp due to Sharpe’s contribution:

According to Markowitz, In a 4- stock portfolio, number of covariance is n(n - 1)= 4(4 -1) = 12
and number of variances are 4. Total number of inputs n +n (n - 1) = 4 + 4(4 - 1)= 16 or
square of n , ( n 2 ) . Since COV i,j is same as COV j,I therefore unique COVs =n(n - 1)/2. Thus
according to Markowitz classical portfolio theory, total number of unique estimated inputs
needed for estimating total risk of portfolio ( VARp ) = n + n (n - 1) /2.

According to Sharpe’s formula for calculating total risk of portfolio (variance of portfolio), you
need fewer estimated inputs. In a 4-stock portfolio you need 4 estimates of betas of 4 stocks
(Bi ) , 4 estimates of either VAR ei , or 4 estimates of VAR i , and one estimate of VARm ,
therefore total number of input estimates needed for VARp calculation = 4 + 4 + 1 = 9. You
can generalize this for a portfolio of n stocks as 2n +1 estimated inputs needed to estimate
total risk of a portfolio.
For 100 Stock portfolio, number of input estimates needed for VARp ( Total risk ) calculations
Markowitz
‘n’ is 100, so VARi of 100 stock.
n(n - 1) / 2 = 100 (100 -1) / 2 = 9,900/2 = 4,950 unique COVs b/w pairs of stock

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Total number of estimated inputd needed = n + n(n - 1) / 2
= 100 + 4,950 = 5,050
Sharpe
100 VARi for 100 stocks ( or 100 VARei for 100 stocks)
100 betas ( Bi ) for 100 stocks
1 = VAR m . It is VAR of Stock Market Returns and quantifies total risk of a stock market
Total estimates needed = n +n + 1 or 2n +1
= 100 + 100 + 1
=201
Computational simplification introduced by Sharpe is significant in terms of requirement of
estimated inputs to calculate total risk of portfolio ( VAR p). You just saw that in case of 100
stock portfolios 5,050 inputs in the form of variance and covariance of stock returns for
Markowitz formula are needed, but you need to estimate only 201 inputs for Sharpe’s formula
to calculate total risk of portfolio.
Analytical Look at Sharpe’s Total Risk of Portfolio
Let us understand the analytical insight provided by Sharp’s formulation of total risk of
portfolio.
According to Sharpe total risk of a portfolio is:
VARp = B2p VAR m + VAR ep
VARp is total risk of a portfolio. B2p VAR m is non diversifiable risk of a portfolio; and it is
composed of 2 components: relevant risk of portfolio (Bp) and market risk of that country’s
stock market (VAR m). In certain text books B2p VAR m is termed as systematic risk of a
portfolio because risk of stock market (VAR m) is part of this expression and stock market
represents the system or country, or economy, as a whole. Please note some text books
wrongly call this term B2p VAR m as market risk; market risk is only VARm part of this term ,
it is better to call the complete term B2p VAR m as systematic risk of portfolio or non
diversifiable risk of portfolio.

The term VAR ep is called portfolio’s company related risk, or idiosyncratic risk, or non
systematic risk, or a better wording is diversifiable risk. This component of total risk is due
to company specific events; as these events are not necessarily same in all the companies so
their impact my cancel out each other, and in a large portfolio this portion of total risk is likely
to be so small that it is negligible; and such portfolios are called well diversified portfolios.
It is helpfull for your understanding to visualise total risk, as per Sharpe, in the manner given
below:

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VARp = B2p VAR m + VAR ep

Total Risk = systematic risk + company specific risk; and this risk is called by different names
such as unique risk, un systematic, idiosyncratic risk.
Total Risk= non- diversifiable risk + diversifiable Risk
Total Risk = (relevant risk squared * market risk ) + diversifiable risk

Please notice you have 5 different measures of risks related to a portfolio in the above
formula, namely, total risk, diversifiable risk, non-diversifiable risk, relevant risk , and market
risk. You should be able to calculate those. Please note all these 5 risks are also applicable
not only to portfolios but also to a single stock according to Sharpe. You can speak about
diversifiable risk and non diversifiable risk of stock of PSO along with its total risk and its
relevant risk. Also note that for all stocks and all portfolios the market risk is same as long as
they are built in Pakistani market. The term VAR ep (variance of error term of portfolio)
shrinks and can approach zero as number of stocks in a portfolio are increased; and therefore
this component of total risk is termed by Sharpe as diversifiable risk of portfolio. Next you
shall see with the help of data how diversification reduces total risk of portfolio according to
the Sharpe’s formulation of total risk of portfolio.

How does diversification work in Sharpe’s Model:

In an equally weighted portfolio of N stocks, weight of each asset is same:
X1 = X2 = ……………. Xn = 1/N
For example in an equally weighted portfolio of 10 stocks, %age of your OE invested in each
stock is 1/N =1/10 or 0.10 or 10% ; so X1 to X10 all are 0.1 or 10%.
We know that Sharpe proved that:
VARp = B2p VAR m + VAR ep
VARp = B2p VAR m + ∑ X2i VAR (ei). Now insert 1/N as weight of each stock in an equally
weighted portfolio, so the Xi is replaced by 1/N, and you have:
=B2p VAR m + ∑ (1/N) (1/N) VAR ei
= B2p VAR m + 1/N [ ∑ VARei / N]
As ∑VAR(ei) /N = sum of variances of error terms of all stocks in the portfolio divided by
number of error terms (or number of stocks), so it is Average VAR(ei)

VARp = B2p VAR m + (1/ N * Avg VAR ei)

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Please remember this equation is mathematically valid ONLY for the total risk of an equally
weighted portfolio.
If number of stocks in a portfolio is very large, that is, if N approaches infinity, then 1/N
approaches zero and the term {1/N * Avg VAR (ei)} also approaches 0, so this portion of total
risk of portfolio can be made to approach zero just by adding more stocks in the portfolio.
Therefore for a portfolio with many stocks, its total risk is:
VAR p = B2p VAR m + almost zero [when N is approaching ∞]
Why B2 p VARm cannot be made to approach zero by adding more stocks in the portfolio ?
VARm is always present as positive number; and it is same for all portfolios regardless of which
portfolio manager made it as long as portfolios are being made in that particular market such
as Pakistan. But the portion Bp2 can be managed by a portfolio manager as she has a choice
to include low beta stocks to build a low beta portfolio; or include high beta stocks to build a
high beta portfolio. Therefore only risk that is relevant for portfolio managers’ decision
making is beta of stocks included in the portfolio, hence beta of stock is called relevant risk
of that stock, and beta of portfolio is called relevant risk of portfolio. Relevant in this context
refers to relevant for making decision about total risk of portfolio.

As Bi is part of non diversifiable risk of a stock, then if you included stocks with high beta then
resulting portfolio’s beta (Bp) would also be high , and that ultimately would result in high non
diversifiable risk of portfolio (B2p VAR m ), which finally results in higher total risk of portfolio
(VARp). Since portfolio managers are given a target or bench mark beta by their bosses, let us
see how diversification works when we build portfolios with different number of stocks but
keep the beta at the given target.

Exercise : Please build equally weighted portfolios. Suppose Avg VAR (ei) is 100%2 for all stocks
in Pakistan, that is the diversifiable risk on average is 100 in Pakistani stocks. Your target is to
keep Bp = 1.2 for your portfolios as that is the risk target given by your boss, and suppose that
total risk of Pakistani market, (i.e. variance of returns of KSE-100 Index) VARm = 25 %2, Please
build equally weighted portfolios if number of stocks (N) = 1, 2, 4, 10, 40, 100, 200, 400 and
find total risk of portfolio, i.e. VARp.
Non-Diversifiable Risk + Diversifiable Risk = Total Risk
N of portfolio B2 pVARm + 1/N Avg VARei = VARp
2
1 ( 1.2) *25 + 1/1 * 100 = 36+100 =136
2 ( 1.2)2 * 25 + 1/2 * 100 = 36+50 = 86
4 (1.2)2 * 25 + 1/4 * 100 = 36+25 = 61

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10 (1.2)2 * 25 + 1/10 * 100 = 36+10 = 46
40 (1.2)2 * 25 + 1/40 * 100 = 36+2.5 = 38.5
100 (1.2)2 * 25 + 1/100 * 100 = 36+1 = 37
200 (1.2)2 * 25 + 1/200 *100 = 36+0.5 = 36.5
2
400 (1.2) * 25 + 1/400 * 100 = 36+0.25 = 36.25
In the table given above, as number of stocks increased in a portfolio, total risk decreased ,
diversifiable risk (1/N Avg VARei ) decreased from 100 to 0.25, a significant decrease
approaching to zero . But non - diversifiable risk (Bp2 VARm ) remained at 36. Please note that
total risk of portfolio (VARp ) kept on decreasing as you kept on increasing number of stocks,
but most of the decrease was achieved by the time 40 stocks were in the portfolio as total risk
declined from 136 to 38.5. Non-diversifiable risk (Bp2 VARm ) remained constant at 36, it is not
reduced by increasing the number of stocks and therefore it is non-diversifiable risk. Please
note that you had diversified 75% of total risk by the time you had 40 assets in the portfolio;
and diversifiable risk was down to 2.5 from 100; a 97.5% decline in diversifiable risk
( 2.5 - 100) / 100 = - 0.975.
Therefore in practice, a portfolio composed of 40 assets is considered well diversified; even
10 assets are good enough because in our example by the time there were 10 stocks in the
portfolio the diversifiable risk was down to 10 from 100; that is a 90% decline: (10 – 100) /100
; and total risk was down to 46 from 136, that is 66% decline in total risk :(46 -136)/136.

The Concept Of Average Beta, Building Low Risk Portfolios

In real life portfolio managers are given target beta for their portfolios and according to this
bench mark they decide about including stocks in their portfolio. Let us pay attention to it:
Bp2 = (∑ Xi Bi)( ∑ Xi Bi), since for equally weighted portfolio Xi = 1/N so we can write
Bp2 = ∑ (1/N) Bi * ∑(1 / N) Bi. And it can be written as [∑Bi / N] * [∑Bi / N]. Note: ∑Bi /N is
sum of betas divided by number of betas (or number of stocks) , and that is called average
beta. So:
Bp2 = average beta * average beta.
Note also that the N is largest when maximum number of stocks are in your portfolio; it
happens when all the stocks present in the market are included in your portfolio, for example
all stocks listed at KSE. But that means beta of such a portfolio is same as beta of stock market,
and you have already proven that beta of any stock market is always one, so when N is very
large then average beta should be same as market beta, that means beta of such a portfolio
would be one. Therefore:
∑Bi / N * ∑Bi / N = Avg Bi * Avg Bi . Since Avg Beta is 1 always.

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Bp2 = Avg B * Avg B = 1 x 1 = 1
So, If N is very large , and 1/N approaches zero, then B2p approaches 1 , but still the term Bp2
VARm cannot be made to approach to zero because VAR m is still there; and it is the total risk
of a stock market which is a macro-economic fact and cannot be reduced by any portfolio
manager as long as she has build her portfolio in a particular market such as Pakistan.
But the term B2p VARm can be reduced to (1)2 VARm , as you saw above that beta can be 1 if all
stocks are included
So in a large equally weighted portfolio with many stocks in it:
VARp = Bp2 VARm + VARep
VARp = 12* VARm + Almost zero
that is, total risk of such a portfolio is equal to market risk (VARm); please note this result was
derived for an equally weighted portfolio, but it is applicable to all portfolios.
Note: Since VARm is same for all the portfolio managers in Pakistan, they all have to accept it
as part of the total risk of their portfolio. Therefore it is Bp2 portion of total risk of a portfolio
that a portfolio manager can attempt to manage by selecting low or high beta stocks for her
portfolio, therefore Bi is the relevant risk of a security from portfolio management view point
because it influences Bp.

An interesting question arises:

is it possible for a portfolio manager to build a portfolio whose total risk is less than the market
risk, that is, VARp is less than VARm? The answer is yes! A portfolio manager can build a
portfolio whose total risk is much lower than the total risk of stock market by selecting low
beta stocks and thereby having portfolio beta less than the market beta of 1, for example
portfolio manager can build a portfolio whose beta is 0.5. The resulting total risk of such a
portfolio would be:
Total risk of portfolio = 0.52 VARm + almost zero VAR ep
If VARm is 64, then total risk of such a portfolio would be : 0.52 * 64 + almost zero VAR ep. And
that would work out to 16 as total risk of the portfolio; so such a portfolio’s total risk would
be one-fourth of the total risk of the stock market that was 64.

Since VARm is a given fact in a society so no portfolio manager can get rid of it. You just saw
with the example of an equally weighted portfolio that VARep can be made zero by having a
large number of stocks in your portfolio, that is, large N. Therefore only manageable or
controllable item whose contribution to the total risk of portfolio you as portfolio manager

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can attempt to mange is the Bp, and that depends on betas of individual stocks included in the
portfolio by the portfolio manager.
Since Bp = ∑ Xi Bi = X1 B1 + X2 B2 + …………. + Xn Bn (1 to n are different stocks)
Therefore, Beta of each security is the relevant contributor to the total risk of portfolio. In
finance literature relevant risk of a stock is beta of that stock. So each stock’s contribution
to total risk of portfolio is beta of that stock. To build low risk portfolio, you as portfolio
manager, should include those stocks in your portfolio which have a low beta.

In the context of Sharpe’s formulation of total risk of portfolio, when a stock is called as low
risk or high risk , we are referring to their beta. As stock market beta is considered average
beta and it is ALWAYS ONE, therefore with reference to market beta a stock is categorized as
high risk or aggressive if its beta is more than one; and low risk or defensive if its beta is less
than one; and the same is true for a portfolio.
Low risk stock or low risk portfolio: Bi < 1 (defensive stock or portfolio)
High risk stock or high risk portfolio: Bi > 1 (aggressive stock or portfolio)
Average risk stock or portfolio: Bi = 1, and it is also the beta of stock market

An Important Point of General Knowledge

Please note percentage decrease is never more than 100% because when something has
declined 100% then it is no more in existence; in case of stock value or currency value it means
stock or currency is worthless if decline is 100%; and there is no possibility of further decline
in stock value or currency value. Therefore when you read in print media or watch electronic
media reporting 134% decline in value of rupee against US dollar during last 4 years, YOU
SHOULD KNOW THEY DON’T REALLY KNOW WHAT THEY ARE TALKING ABOUT. This error
occurs due to using ending value in denominator; whereas percentage decline or rise should
always be calculated based on beginning value.
For example in 2008 US dollar was 60 rupees (0.01667$ = 1 Rs), in 2013 it was 90 rupees
(0.01111$ = 1 Rs). You would conclude that rupee depreciated against dollar, therefore value
of rupee in dollars should be used:
= (Ending value of Rs – beginning value of Rs ) / beginning value of Rs
=(0.01111- 0.01667) /0.01667
=-0.00556 / 0.1667
= -0.3335
=-33.35%
And you would conclude that rupee has depreciated against US dollar by 33.35% from 2008
to 2013.

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On the other hand if you want to talk from US perspective and want to say about appreciation
of US dollar against Pak rupee, you would say dollar appreciated between 2008 and 2013 by:
= (ending value of dollar – beginning value of dollar) / beginning value of dollar
= (90 - 60)/60
= 30/60
=0.5
=50%
And you would conclude that US dollar has appreciated 50% against Pak rupee between 2008
and 2013.

Please note: percentage loss in value of rupee was 33.35% but percentage gain in value of
dollar was 50%. It is always that way; percentage gain is always higher than percentage loss;
and percentage loss in value of shares or currencies can never be more than -100%, but
percentage gain can be more than 100%.

For example: US dollar beginning of 2016 was 110 rupees (0.00909 $ = 1 Rs) and by the end of
2016 is estimated to be 500 rupees (0.002 $ = 1 Rs)
Expected Depreciation in value of rupee = (0.002 – 0.00909)/0.00909 = -77.99%
Expected Appreciation in value of $ = (500 - 110) / 110 = 354.54%
Again notice that depreciation is less than 100% but appreciation is more than 100%.
As business graduates, this is the type of mistake you are expected not to make; never say a
currency lost value by more than 100% or a share lost value by more than 100%; but a currency
or a share can gain value by more than 100%.

Following is the summary of what you have learnt up till now about risk
and return of stand-alone stocks as well as portfolio of stocks:
Stand Alone Stock
Markowitz
Expected ROR of single stock (Ri) = Expected dividend yield + Expected capital gains yield
Total Risk of single stock (VAR i) = ∑(Rit - Avg Ri )2 /n . ‘ t’ varies from year 1 to year n.

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Sharpe
Expected ROR of single stock, Ri = αi + Bi Rm
Total Risk of single stock (VARi ) = B2i VARm + VARei
= Non-Diversifale + Diversifiable risk

Portfolio of Stocks
Markowitz
Expected Rp = ∑Xi Ri
VARp = ∑Xi2 VARi + ∑∑Xi Xj COVi,j ( i is not j)

Sharpe
Expected Rp = αp + Bp Rm ; while αp = ∑Xiαi , and Bp = ∑XiBi
VARp =Bp2 VARm + VARep ; while VARep = ∑Xi2 VAR ei

Coefficient of determination :R2 = Systematic Risk / Total Risk

= Bi2 VARm / VARP .
If total risk is taken to be 100% or 1 then R2 tells what %age of total risk is non diversifiable;
the remaining %age of total risk is diversifiable risk (1 – R2). R2 is called Co-efficient of
determination, and it shows %age of changes or variations in returns of a stock or a portfolio
due to variations in market return. Please note you can find correlation (R) between portfolio
returns and market returns (CORR p,m ) by taking under root of R2, that is √ R2 , and the same
applies to correlation of a stocks return with the market returns,
CORR i ,m = √R2
Example
If for a portfolio you know its Beta is 1.2; risk of stock market is 25; and portfolio’s diversifiable
risk is 10, then total risk of this portfolio is:
VAR p = B2 p VAR m + VARep
= (1.2)2 25 + 10
= 1.44 x 25 + 10
= 36 + 10
=46
Dividing the whole equation by Total Risk, i.e. VARp
VAR p / VARp = B2p VARm / VARp + VARep / VARp
46/46 = 36/46 + 10/46

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1 = 0.78 + 0.22
1 = R2 + (1 - R2)
TSS = ESS + RSS
78% of total risk of this portfolio is systematic, i.e. non diversifiable
22% of Total risk is diversifiable. In this case 78% variations in dependent variable (that is Rp)
are explained by variations in the independent variable (Rm) according to Sharpe’s
Expected Rp = αp + Bp Rm.
Note : correlation of returns of this portfolio with the stock market return sis :
CORRp,m = √ R2 = √0.78 = 0.88
Correlation of 0.88 means a strong correlation between returns of this portfolio and returns
of stock market. Please note that beta is a ratio: Beta of portfolio = COV p, m /VAR m; and VARm
is = SDm * SDm; You also know that covariance is:
COV p, m = CORR p, m * SDp * SDm.
Therefore Beta = (CORR p, m * SDp * SDm) / (SDm * SDm). And that simplifies to:
Beta = (CORR p, m * (SDp / SDm). As you know that SD cannot be negative, but correlation
can be negative between returns of a stock and return of stock market, therefore beta of a
stock can be negative and same is true for beta of a portfolio, though in real life building such
a portfolio is desirable but challenging.

Exercise: Markowitz & Sharpe methods give similar Rp, VARp, SDP.
Please make sure you understand the following exercise fully
Your staff of security analysts have the following estimates for stocks A , B, C, and D:

αi βi VARi
Stock
A 2% 1 200%
B 3 1.20 130
C 1 1.5 180
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D 2 0.75 50
 Please note alpha is percentage, but beta is just number, it is not a percentage.
expected ROR of stock market (Rm ) for the next year is estimated to be 10% and total
risk of stock market (VAR m ) is estimated 70%2.
Required:
Q1: Please build an equally weighted portfolio of 4 stocks a, b, c, and ; show that ∑Xi = 1
Q2: Find expected return of each stock using Sharpe’s linear Market Model.
Q3: Find expected return of portfolio, Rp as :
i) ∑Xi Ri (Markowitz)
ii) ap + Bp Rm (Sharpe)
Q4: Find total risk of portfolio, VARp as :
i) Xi2 VARi + ∑∑ Xi Xj COVi,j (Markowitz)
ii) B2p VARm + VAR ep (Sharpe)
Q5: What is: 1) non diversifiable risk; 2) diversifiable risk; 3) relvant risk; 4) market risk in this
portfolio?
Q6: What percentage of its total risk is diversifiable and what percentage is non diversifiable
Q7: In your view, is it a well diversified portfolio?
Q8: In your view, is it a high risk portfolio?
Q9: What is correlation of portfolio return with the market return?
Solution :
Q1: In an equally weighted portfolio weight of each stock is equal, Xa = Xb = Xc = Xd = 1/N . As
in this case N = 4 so each X is 1/N = ¼ = 0.25
∑Xi = Xa + Xb + Xc + Xd
= 0.25 + 0.25 + 0.25 + 0.25
∑Xi = 1

Q2: Expected Return of each stock, according to Sharpe’s Market model:

Ri = αi + Bi Rm
(note: ei is not used b/c its expected value is zero)
Expected ROR of each stock using Sharpe linear relationship between Ri and Rm

αi + Bi Rm = Ri
A 2 + 1(10%) 12%
17 | P a g e B 3+ 1.2(10%) 15%
C 1+ 1.5(10%) 16%
D 2 + 0.75(10%) 9.5%
Q3 Expected return of portfolio
Markowitz
Rp = ∑Xi Ri
= Xa Ra + Xb Rb + Xc Rc + Xd Rd
= 0.25(12%) +0.25(15%) + 0.25(16%) + 0.25(9.5%)
= 3% + 3.75% + 4% + 2.375%
= 13.125%
Sharpe:
Rp = αp + Bp * Rm
Where αp = ∑Xiαi
αp = Xa αa + Xb αb + Xc αc + Xd αd
= 0.25 (2) +0.25 (3) +0.25 (1) +0.25 (2)
= 0.5 + 0.75 + 0.25 + 0.5
= 2%
Bp = ∑Xi Bi
Bp = Xa Ba + Xb Bb + Xc Bc + Xd Bd
= 0.25(1) + 0.25(1.2) + 0.25(1.5) +0.25(0.75)
= 0.25 + 0.3 + 0.375 + 0.1875
= 1.1125
Inserting values of alpha of portfolio and beta of portfolio and expected return of market in
Sharpe model:
Rp= ap + βpRm
Rp = 2% + 1.1125(10%)
Rp = 2 + 11.125%
Rp = 13.125%
Note it is same as given by Markowitz formula above.

Q4 : Total risk of portfolio( VARp )

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Markowitz
VARp = ∑Xi 2VARi + ∑∑Xi Xj COVi,j
Since COVi,j = Bi Bj VARm as proved by Sharpe, therefore you can find COVs
COVa,b = Ba Bb VARm
= 1 X 1.2 X 70 = 84
COVa,c = Ba Bc VARm
= 1 X 1.5 X 70 = 105
COVa,d = Ba Bd VARm
=1 X 0.75 X 70 = 52.5
COVb,c = Bb Bc VARm
=1.2 X 1.5 X 70 = 126
COVbd = Bb Bd VARm
=1.2 X 0.75 X 70 = 63
COVc,d = Bc Bd VARm
=1.5 X 0.75 X 70 = 78.75
∑Xi 2VARi = Xa2 VARa + Xb2 VARb + Xc2 VARc + Xd 2VARd
= (0.25)2 200 + (0.25) 2130 + (0.25)2 180 + (0.25)2 50
= 12.5 + 8.125 + 11.25 + 3.125
= 35%
The second term is:
∑∑Xi Xj COVi,j = Xa Xb COV a,b + Xa Xc COV a,c + Xa Xd COV a,d
+ Xb Xa COV b,a + Xb Xc COV b,c + Xb Xd COV b,d
+ Xc Xa COV c,a + Xc Xb COV c,b + Xc Xd COV c,d
+ Xd Xa COV d,a + Xd Xb COV d,b + Xd Xc COV d,c
For example : Xa Xb COV a,b = 0.25 * 0.25 * 84 = 5.25. Similarly other values were calculated
for the terms in covariance matrix given above, inserting these values we get the following :
∑∑Xi Xj COVi,j = 5.25 + 6.56 + 3.28
+ 5.25 + 7.875 + 3.94
+ 6.56 + 7.875 + 4.92
+ 3.28 + 3.94 + 4.92
= 63.65%
VARp = ∑Xi2 VARi +∑∑Xi Xj COVi,j ( i≠j )
= 35%2 + 63.65%2
= 98.65%2
SDp = √VARp = √98.65% 2 = 9.93%

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 Sharpe:
VARp = Bp2 VARm + VARep
We need to calculate diversifiable risk ( VAR e p ) of portfolio as the other data is avaialable to
calculate total risk of portfolio. We know that VARep = ∑Xi2 VAR ei. For individual stocks we
are given VAR i, and betas, and we also have total risk of market (VAR m ). So we can find for
each stock its diversifiable risk (VARe i ).
Sharpe proved that total risk for a stock is: VARi = Bi2 VARm + VARei .
so: VARei = VARi - Bi2 VARm. Using this formulation we can estimate diversifiable risk (VARei
) of each stock as follows:
Stock VARi – Bi2 VARm = VARei
A 200 –(1)2 * 70 =130
B 130 –(1.2)2 * 70 =29.2
C 180 –(1.5)2 * 70 =22.50
D 50 –(0.75)2 * 70 =10.62
VARep =∑Xi2 VARei
=Xa2 VAR(ea) + Xb2 VAR(eb)+ Xc2 VAR(ec)+ Xd2 VAR(ed)
=(.25)2*130 + (.25)2*29.2 + (.25)2*22.5 +(.25)2*10.62
=12.02

VARp = B2p VARm + VARep

VARp =(1.1125)2 *70 +12.02
86.63 + 12.02
=98.65%
So: Both formulations, that of Markowitz and that of Sharpe, give exactly same answers for Rp
and VARp.

Q5: What is 1) non diversifiable risk; 2) diversifiable risk; 3) relvant risk; 4) market risk in this
portfolio
Non diversifiable risk is 86.63%2
Diversifiable risk is 12.02%2
Relevant risk is 1.1125
Market risk is 70%2

Q6: What percentage of its total risk is diversifiable and what percentage is non diversifiable?

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86.63 / 98.65 = 0.878 or 87.8% of total risk is non diversifiable, it is also R squared or co-
efficient of determination.
12.02 / 98.65 = 0.122 or 12.2% of total risk is diversifiable

Q7: In your view, is it a well diversified portfolio?

As only 12% of its total risk is diversifiable therefore it seems like very diversified poprtfolio as
most of its total risk is non diversifiable. If a portfolio had 80% or 90% of its total risk as
diversifiable risk then you would say it is not very well diversified. In any case since this
portfolio has some of its risk as diversifiable risk therefore strictly speaking it is not a fully
diversified portfolio; in a fully diversified portfolio diversfiable risk would be zero % of its total
risk. Later in this course you would learn how to build fully diversified portfolios whose total
risk is composed of only the non-diversifiable risk , and such portfolios have zero diversfiable
risk.

Q8: In your view, is it a high risk portfolio?

As beta of this portfolio is more than one, so it is higher risk portfolio. Please remember that
only relevant risk in judging a portfolio as high or low risk portfolio is the beta of portfolio ,
and you would judge based on its beta 1.1125 that more than one , and therefore it is high
risk portfolio.

Q9: Correlation of portfolio return with the market return?

Correlation P, m = √R2 = √0.8663 = 0.93

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