SECURITY ANALYSIS & PORTFOLIO MGT.

Sharpe Index Model

Group Members
1. 2. 3. 4. Esha Khosla Amit Goyal Samarpit Nagpal Sakshi Sarin 61 62 63 64

THE SHARPE INDEX MODEL

Generally, when the Sensex rises, stock prices also tend to increase and vice versa. Thus, stock prices are related to the market index and this relationship can be used to estimate the return on stock.

In that regard, the following equation can be used; Ri= i + iRm + ei

where, Ri= expected return of security i i= alpha coefficient(intercept of the straight line) i= beta coefficient (slope of the straight line) Rm = the rate of return of market index ej =error term

According to the above equation, the return of a stock can be divided into two components; 1)The return due to the market, 2)The return independent of the market
i of 1 indicates that the market return and security return are moving in tandem.

The Sharpes Single Index Model is based on the assumption that stocks vary together because of the common movement in the stock market and there are no effects beyond the market(i.e. any fundamental factor effects) that account the stocks co-movement.

The expected return, standard deviation and co-variance of the single index model represent the joint movement of securities. The mean return is:

Ri= i + iRm + ei
The variance of securitys return is:

=im + ei
The covariance of returns between securities i and j is:

ij = ijm

The variance of the security has two components:

1)Systematic risk is the variance explained by the market index. Systematic Risk =i x variance of market index

=im

2)Unsystematic Risk=total variance systematic risk = ei = i systematic risk Thus, Total Risk=Systematic Risk-Unsystematic Risk =i + ei

From this, the portfolio variance can be derived;

p = [ (Xii)m] + [ Xi ei]
Where, p = variance of portfolio m = expected variance of market index ei= variation in security return not related to the market index xi = the portion of stock i in the portfolio

Likewise, expected return on the portfolio also can be estimated. For each security ai and i should be estimated.

Rp=Xi(ai + iRm)
Portfolio return is the weighted average of the estimated return for each security in the portfolio. The weights are the respective stocks proportions in the portfolio.

A portfolios Alpha is a weighted average of the alpha values for its component securities using the proportion of the investment in a security as weight.

ap= Xiai
Where,

ap= value of the alpha for the portfolio Xi= proportion of the investment on security i ai= value of alpha for security i

Similarly, a portfolios beta value is the weighted average of the beta values of its component stocks using relative share of them in the portfolio as weights. p= xii where, p= portfolio beta

Problem 1: The following information is given for stocks of Company A and Company B and the BSE Sensex for a period of one year. Calculate the systematic and unsystematic risks for the stocks. If equal amount of money is allocated for the stocks what would be the portfolio risk?
Particulars Average return Variance of return Correlation coefficient Stock A 0.15 6.30 0.71 0.424 Stock B 0.25 5.86 0.27 Sensex 0.06 2.25

Coefficient of 0.18 determination

Ans. Company A: Systematic Risk=i x Variance of Market Index =(0.71) x 2.25=1.134 Unsystematic Risk=Total Variance Systematic Risk ei = i systematic risk =6.30-1.134=5.166 Total Risk =Systematic Risk + Unsystematic Risk = i + ei =1.134 + 5.166=6.30

Company B: Systematic Risk =(0.27) x 2.25=0.1640 Unsystematic Risk=(5.86-0.1640)=5.696 Total Risk =(0.1640+5.696)=5.86 p = [ (Xii)m] + [ Xi ei] =[(.5 x .71 + .5 x .27) 2.25] + [(.5)(5.166) + (.5)(5.696)] =[(.355 +1.35) 2.25] + [(1.292 + 1.424)] =(.540 + 2.716) =3.256

SHARPES OPTIMAL PORTFOLIO

Sharpe had provided a model for the selection of appropriate securities in a portfolio. The selection of any stock is directly related to its excess return-beta ratio.

Ri - Rf/i
where, Ri = the expected return on stock i

Rf= the return on a risk less security i = the expected change in the rate of return on stock i
associated with one unit change in the market retrun.

The excess return to beta ratio measures the additional return on a security(excess of the risk less security return) p.u. of systematic risk or non-diversifiable risk. This ratio provides a relationship between potential risk and reward. Ranking of the stocks are done on the basis of their excess return to beta.

The selection of the stocks depends on a unique cut-off rate such that all stocks with higher ratios of Ri - Rf/i are included and the stocks with lower ratios are left out

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 consideration. Step 2: Rank them from the highest to the lowest. Step 3: Calculate C, for all the stocks according to the ranked order using the following formula: Step 4: 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.

N m2 i=1 (Ri Rf)i ei2

Ci =
1 + m2

N
i2 ei2 i =1

Where,

m2 = Variance of the Market Index

ei2 = Variance of a stocks movement that is not associated with the movement of Market Index i.e. stocks unsystematic risk.

EXAMPLE -1:

SOLUTION OF EXAMPLE- 1:

Thank u.