The Sharpe Index Model

To understand the basics of Sharpe Index

model
To calculate the systematic and unsystematic
risk
To know the concept optimal portfolio
In Markowitz model a number of co-variances have to be
estimated.
If a financial institution buys 150 stocks, it has to
estimate 11,175 i.e., N(N 1)/2 correlation
co-efficients.
Sharpe assumed that the return of a security is linearly
related to a single index like the market index.
It needs 3N + 2 bits of information compared to
[N(N + 3)/2] bits of information needed in the Markowitz
analysis.
Need for Sharpe Single Index Model
Single Index Model
Stock prices are related to the market index and
this relationship could be used to estimate the
return of stock.
R
i
= a
i
+ b
i
R
m
+ e
i
where R
i
expected return on security i
a
i
intercept of the straight line or alpha co-
efficient
b
i
slope of straight line or beta co-efficient
R
m
the rate of return on market index
e
i
error term
Systematic risk = b
i
2
variance of market index
= b
i
2
s
m
2 variance explained by the index
Unsystematic risk = Total variance Systematic risk
e
i
2
= s
i
2
Systematic risk
( unexplained variance)
Thus the total risk = Systematic risk + Unsystematic risk
= b
i
2
s
m
2
+ e
i
2
Variance of the security has two component namely systematic risk & unsystematic risk.
Risk
Portfolio Variance
The portfolio variance can be derived


where
= variance of portfolio
= expected variance of index
= variation in securitys return not related to the market index
x
i
= the portion of stock i in the portfolio
e
2
i
o
2
N N
2 2 2 2
p i i m i i
i =1 i =1
= x + x e
(
| | (
o
(
(
|
\ .
(



2
p
o
2
m
o
Expected Return of Portfolio
For each security a
i
and b
i
should be estimated

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.
Strongly efficient market All information is reflected on prices. Weakly efficient market All historical information is reflected on security Semi strong efficient market All public information is reflected on security prices Strongly efficient market All information is reflected on prices. Weakly efficient market All historical information is reflected on security Semi strong efficient market All public information is reflected on security prices Strongly efficient market All information is reflected on prices. Weakly efficient market All historical information is reflected on security Semi strong efficient market All public information is reflected on security prices
N
p i i i m
i =1
R = x ( + R )

Portfolio Beta
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.



b
p
is the portfolio beta.
N
p i i
i =1
= x | |

SHARPES OPTIMAL PORTFOLIO

The selection of any stock is directly related to its excess
return-beta ratio.

where R
i
= the expected return on stock i
R
f
= the return on a risk free asset
b
i
= the expected change in the rate of return
on stock i associated with one unit change in
the market return
i f
i
R R

Optimal Portfolio
The steps for finding out the stocks to be included in
the optimal portfolio are as:
Find out the excess return to beta ratio for each stock
under consideration
Rank them from the highest to the lowest
N
2
i f i
m
2
i =1
ei
i
2
N
2
i
m
2
i =1
ei
(R R )

1+

Proceed to calculate C
i
for all the stocks according to the
ranked order using the following formula
s
m
2
= variance of the market index
s
ei
2
= variance of a stocks movement that is not associated
with the movement of market index i.e., stocks
unsystematic risk
The cumulated values of C
i
start declining after a particular C
i

and that point is taken as the cut-off point and that stock
ratio is the cut-off ratio C.