STOCK EXCHANGE & PORTFOLIO MANAGEMENT

B.R.C.M COLLEGE OF BUSINESS ADMINISTRATION

STOCK EXCHANGE & PORTFOLIO MANAGEMENT

TOPIC: SHARPE MODEL

T.Y B.BA (FINANCE)

PREPARED BY : MODI VIRAL - 36

SUBMITTED TO :

Mr. MRUNAL JOSHI

SUBMITTED ON :

07/03/2012

STOCK EXCHANGE & PORTFOLIO MANAGEMENT Portfolio Theory

Portfolio consist different sets of assets of financial nature such as gold, silver, real estate, insurance policies, post office certificates, etc. for making the provisions for future. Basket of all the investment or assets held by an individual or any corporate body or any economic unit is called portfolio. A portfolio is a basket of investments or assets held by an individuals or corporate body.

Portfolio management

Each of the investment avenues has their own risk & returns investor plans his investment as per this risk- return profile or his preferences while managing his portfolio efficiently so as to secure the highest returns for lowest possible risk. This in short is the portfolio management.

Portfolio management is the process of encompassing many activities of investment in assets & securities which includes planning, supervision, timing, rationalization, etc. in selection of securities to meet investors objectives.

Investment management is another word which can be used for portfolio management. Investment management

It is the professional management of various securities (shares, bond) assets (e.g real assets), to meet specified investment goals for the benefits of the investors. Investor many be institutions (insurance companies. Pension funds, corporation ets) or private investors (both directly via investment and more commonly via collective investment schemes e.g. mutual funds)

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SHARPE MODEL

William f. Sharpe developed the capital assets pricing model (CAPM). He

emphasized the risk factor in portfolio theory is a combination of two risks i.e. systematic and unsystematic risk.

The systematic risk attached to each of the security is same irrespective of any number of securities in the portfolio. The total risk of portfolio is reduced, with increase in number of stocks, as a result of decrease in the unsystematic risk distributed over number of stocks in the portfolio.

Markowitz model had practical limitation related to compiling expected

return, standard deviation, variance of each security to every other security in the portfolio. Sharp model has simplified this process by relating the return in a security to a single market index.

Firstly, this will theoretically reflect all well traded securities in the

market. Secondly it will reduces and simplify the work involved in compiling elaborate matrices of variance as between individual securities. The market index is used as surrogate for other individual securities in the portfolio the relation of any individual security with market index can be represented in a regression line.

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The following are the features and functions of the custom Sharpe-based portfolio optimization model:
1. Automated Historical Stock Price Acquisition

The Sharpe model designed by Appian Analytics provided automatic download of historical stock price information.
2. Sector Based Management & Optimization

The hedge fund required a sector-based approach to managing, monitoring, and optimizing holdings. This sector-based approach was designed into the optimization model to allow for optimization of individual sector holdings and accommodated up to 20 different sectors.
3. Minimum and Maximum Constraints

The Sharpe optimization model was designed to allow the investment managers to override the overall optimization algorithm with minimum and maximum constraints. These constraints included minimum/maximum number of shares to hold or minimum/maximum total percent of sector value. 4. Fully Automated Optimization

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Using the stock prices, expected values, and any user defined constraints, the Sharpe optimization model will automatically download stock prices, calculate expected return, calculate risk as measured by the standard deviation, and calculate prospective weights to maximize potential return while minimizing risk. 5. Standard Excel Based Solution The Sharpe model was able to be used throughout the organization capabilities. by using standard Microsoft Excel functions and

Sharpe assumed that the return on security could be regarded as being leanerly related to a single index like the market index theoretically a market index should consist of all the securities trading in the market. The simplified model has come to be known as the market model or single index model. Where the market falls grametically all stocks go down together.

The relationship between return on individual securities & returns on market portfolio can be expressed by using a characteristics line or regression line is drawn below with excess return on the security (i.e. security return risk free return) on y-axis & excess return on the market portfolio (i.e. market return- risk free return) on x-axis.

This simplify model has come to be known as market model or single index model.

Y Ri-Rf = + im *(Rm-Rf) + ei

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Ri-Rf

im

Rm-Rf X

The relationship between return on individual security & the return on market portfolio can be expressed by using of characteristic line or regression line.

Characteristic line:

Ri-Rf = + im *(Rm-Rf) + ei

Where, Ri = the holding period return on security I. Rf = the riskless/ risk free rate of interest. Rm= holding period return on market index. im = coefficient of regression line of security I on m

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Securities with values >1 are termed aggressive.

Securities with values <1 are termed defensive.

The residual component of unsystematic return known as error

Optimal portfolio of sharpe:

The desirability of any security is directly related to its excess return to ratio. i.e (Ri-Rf/im) if the securities are ranked by ratio ranking representing desirability of security in portfolio. The no. of security selected depends on unique cut off rate that all securities with higher ratio.

Two steps are important for optimal portfolio.

1) Calculate ratio & rank highest to lowest for each security.

2) Optimum portfolio consist security having grater ratio than a particular

cut off point (i.e. c*)

Formula for cut off rate:

Ci=m *[ ( Ri-Rf/im) ] ei

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1 + m * (im/ ei)

Where, Ci= cut off rate m = variance of market index. ei = residual variance

To construct optimum portfolio the % invested for each selected

security in optimal portfolio is to be calculated the % invested in each security.

formula for weightage: xi= zi /zi

zi= im [(Ri-Rf/im)-C*] ei

where, m = variance of market index ei= variance of error xi= weightage of security i in optimum portfolio of sharpe im= co-efficient of regression line security i on market return m

STOCK EXCHANGE & PORTFOLIO MANAGEMENT The cut off rate is denoted by c*

The steps for finding out the stocks to be included in the optimal portfolio are given below: Step 1 Find out the excess return to beta ratio for each stock under considerations.

Step 2 Rank them from the highest to the lowest.

Step 3 Calculate ci for all the stocks according to the ranked order.

Step 4 The cumulated values of ci start declining after a particular ci and that point is taken as the cutoff point & that stock ratio is the cut off ratio c.