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The initial and original work of William Sharpe argued that the
return of each individual security has two basic components i.e.,
systematic component and non-systematic component. Sharpe
was of the opinion that each security has an association with the
market portfolio and the return of security find an association with
the return of such portfolio. In the absence of market portfolio, a
representative index of the market (like BSE Sensex or Nifty) may
be used. The changes in the return of a security due to this
association are termed as slope of the curve when plotted on a
graph. This association is represented with the help of Beta. At
the same time, each security has returns on account of the
performance of the company and such returns are called non-
systematic component of return; in technical jargon this is called
Alpha component of the return. This alpha component represents
minimum return from security when return on market portfolio or
its representative index is zero.
Original version of william sharpe’s
single index model…. Contd…..
Characteristic
line
Overvalued securities or
portfolio
Residual Risk =
Characteristic line contd…….
Returns of Portfolio
For portfolio return, we need merely the weighted
average of the estimated return for each security
in the portfolio. The weights will be the
proportions of the portfolio denoted to each
security.
n
R p = ∑ (Wiα i ) + β p × R m
=Expected portfolioi =return
1
Rp
= The proportion of the portfolio devoted to stock
Wi
i
n
βp = ∑Wi βi
i =1
Calculation of Return and Risk of
Portfolio Under Sharpe's Model contd...
Risk of Portfolio
Risk of the security or portfolio is calculated by variance
in return or standard deviation of return. Total risk of a
security is represented by the following equation.
Total risk = Unsystematic riskσ+ Systematic risk
2
ei
Variance
Variance = Variance of Security's return
Ri = σ + β × σ
= Unsystematic risk
ei
2of security
i
2 i
m
2
Ri
σ 2
ei
Calculation of Return and Risk of
Portfolio Under Sharpe's Model contd...
Systematic Risk = β ×σ
i
2 2
m
Variance of Portfolio
n
σ = β ×σ + ∑Wi ×σ
2
p
2
p
2
m
2 2
ei
i =1
Efficient Portfolio
An efficient portfolio is the one, which offers
maximum return for a given level of risk or has
minimum risk for the given level of return. This is
identified with the help of dominance principle. As
investors are risk averse and are rational decision-
makers, they always prefer to accept maximum
return by assuming a particular level of risk. In the
long run, only efficient portfolios are feasible.
Under Sharpe's single index model, an efficient
portfolio can be constructed as follows:
Construction of Efficient Portfolio
contd…
Constructing the Efficient Portfolio
Model emphasizes that every individual
security must generate positive excess return;
this implies that mean return or expected
mean return of a security must be more than
the return from risk-free avenue. Here, risk-
free avenue means an avenue on which an
assured and safe (free from default risk)
return is generated.
According to the model desirability of any
security is directly related to its excess return
to beta ratio [(Ri- Rf)/Beta i ],where Rf is the
return on risk free assets.
Construction of Efficient Portfolio
contd…
i =1 σei
Construction of Efficient Portfolio
contd…
σei βi
Construction of Efficient Portfolio
contd…
Conclusion
Sharpe's Model is convenient as compared to
the model of Harry Markowitz. It helps in the
creation of portfolio with less number of
calculations as compared to any other model. In
Sharpe's model association of individual
securities/shares with the index of market is given
importance, instead of correlation between
securities. Only those securities are desirable in
the portfolio, which have positive excess return
over risk free return, All the securities for which
excess return to beta ratio is more than the overall
cut-off point-are included in the portfolio. Such
portfolio is the efficient portfolio and generates the
optimum returns.
Subsequent Modification in the Model
by Considering Risk-Free Return
R i − R f =α i+ β i × ( R m − R f ) + ei
R i = Mean return of the security
R f = Risk-free return
α i = Alpha component, i.e. non-systematic return
(residual return), it is such component of the
excess return when excess return on the market
portfolio is zero
βi = Beta of the security
R m = Mean of the market or index representing the
market
ei = Residual error return, which is considered as
'zero'
Subsequent Modification in the Model by
Considering Risk-Free Return contd…
2. Market Portfolio
It is portfolio in which all the securities of the
market find exactly the same proportion in which
these have a representation in the overall market.
Portfolio created like this represents the
movements of the whole of the market and beta of
such market portfolio is always one “1”. Such
portfolio is the replication of the whole of the
market and moves in alignment with the market.
In the absence of such portfolio, general index of
the market, which is true representative of whole
of the market, can be used.
Subsequent Modification in the Model by
Considering Risk-Free Return contd…
3. Systematic Risk
By systematic risk, we mean the risk, which arises on
account of market wide factors. This risk can never be
eliminated because it is inherit part of the market and
investment activities. These risk factors affect all
investment avenues. This model assumes that
fluctuation in the value of stock relative to that of
another do not depend primarily on the characteristics
of those two securities alone. The two securities are
more apt to reflect a broader influence that might be
described as general business conditions.
Relationships between securities occur only through
their individual relationship with some index. This
relationship with the index is measured with the help of
beta. Beta is a sensitivity measurement, representing
volatility of the returns from a share, given particular
changes in the overall market or index of the market.
Subsequent Modification in the Model by
Considering Risk-Free Return contd…
4. Non-systematic Risk
This is such component of risk, which is
on account of company- wide factors or
the factors specific to a particular
investment avenue. This part of the risk
can either be eliminated completely or
minimized with the help of diversification.
Subsequent Modification in the Model by
Considering Risk-Free Return contd…
Ri − R f = α i + β i × (R m − R f )
The equation has the two coefficients or terms. The
alpha value is the value of excess returns in the equation
when the value of excess returns on the market portfolio is
zero, in other words it is part of excess returns which is
realized from the security even if the market’s excess return
is zero. This is the non-market (unsystematic) component of
security’s return. The beta coefficient is the slope of the
regression line and as such it is measure of the sensitivity of
the stock’s excess return to the movement in the market’s
excess return/market return. The combined term
β i × (that
denotes R m −part
R f ) of excess return, which is due to market
movement. This is the systematic component of security’s
excess return.
Calculation of return and Risk of the
Portfolio Under Sharpe’s Model contd..
Returns of Portfolio
For portfolio return we need merely the weighted
average of the estimated return of each portfolio. The weights
will be the proportions of the portfolio devoted to each
security. n
R p − R f = ∑ (Wiα i ) + β p × ( R m − R f )
i =1
n
β p = ∑ Wi β i
R p = expected portfolio return i =1
n
αp = ∑Wiαi
i =1
Risk of Portfolio
Risk of the security or portfolio is
calculated by variance in return or standard
deviation of return. Total risk of a security
is represented by the following equation.
Total risk = Unsystematic risk+ Systematic
risk
Variance ( R i − R f ) = σ 2
ei + β i × Var( R m − R f )
2
Variance of Portfolio n
σ p = β p × σ m + ∑ Wi × σ ei
2 2 2 2 2
i =1
Systematic Risk of the portfolio
β p2 ×Var ( R m − R f )
Non-systematic Risk of the portfolio
n
∑ i ei
W 2
i =1
× σ 2
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