INTRODUCTION

APPLICATION OF SHARPES INDEX IN PORTFOLIO CONSTRUCTION

The main reason behind this study is to construct an optimal portfolio based on past five years
annual prices, were an investor could achieve an optimal risk-return combination. It can be attained either
by maximizing returns with an accepted level of risk, or by minimizing the risk with a suitable rate of
return. For this purpose it involves a spread of investment amongst the different securities on the basis of
its volatility, as it behaves inversely from one another within the equivalent market conditions. It also
influences the national and international level factors and so on.

Portfolio is a combination of individual assets or securities like stock, bond and money
marketplace instrument. . The procedure of joining the large asset classes in order to attain optimum
return with the lowest risk is called Portfolio Construction.

The theory of portfolio provides a standardized approach to an investors to take decisions on

investing their fund in securities under risk (Mullins 1982 and Butters et. al.). It is mainly based on the
notion that investor is risk-averse. This implies that investors will certainly hold a well-diversified
portfolio instead of investing their whole wealth in a single or few assets. The Investors who are risk-
averse will deny investment portfolios that are worse. They are always willing to consider only risk free
predictions with positive risk premiums. A rational investor is a person who desires to maximize his return
with less risk on his investment in his portfolio. To do so, investors has to construct a portfolio of those
assets which is an efficient (minimum risk for a given expected return) that would comprises of different
classes of assets. To determine an efficient portfolios within an asset class (e.g., stocks) can be attained
with the single index model proposed by William Sharpe.

The Sharpe Single-Index Model (SIM) was developed by William Sharpe for construction
of optimal portfolio using less number of inputs. The modesty is the most important characteristics
of the Sharpe’s single index model. Markowitz‘s model uses a large number of covariance. Taking
indication from the Markowitz, recommended that index to which securities are associated can be
used for the generation of covariance. The single index model was formulated by William Sharpe.

SINGLE INDEX MODEL

Casual scrutiny of prices of stock over a long period of time disclose that most of the stock
prices change with the market index. When the Nifty increase, prices of stocks also turn to increase
and vice-versa. This indicates that some underlying things affect the market index as well as the prices
of stocks. Stock prices are related to market index and this correlation could be used to estimate the
return on the stock. To find this the following formula can be used

R
=

+

R
+
e
Where

Ri - Expected return on security i

i - Intercept of the straight line

Βi - beta co-efficient

Rm - the rate of return on the market index

ei - error term

OBJECTIVES OF THE STUDY

Primary Objectives

To construct an optimal portfolio empirically using the Sharpe’s Single Index Model.

Secondary Objectives

 
To analyse the excess return of companies under CNX FMCG index.



To study the systematic risk and unsystematic risk of the companies under CNX FMCG

index.



To know the Return and Risk of the portfolio from the optimal portfolio construction

using Sharps Index Model.


 
To analyse the stability of returns.

NEED FOR THE STUDY

Portfolio is one of the prima option for investment. Most of the cases investors ambiguity
prevents them from active participation in portfolio investment.to avoid such equivocalness,
various theories has been introduced by the experts to predict the market. As the size of the
transaction expands tools and instruments needed to be advanced so that systematic conclusion
can be made by analyzing all dimensions. With this regard SIM has been introduced to construct
an optimal portfolio. This model overcome with existing models lacunas and helped investors to
have most suitable conclusion on their investment decisions.

SCOPE OF THE STUDY:


 The study is based on equity stocks of each security of companies which are publicly
held.

 Annual average Closing price of stock is used for evaluation of returns.

METHODOLOGY OF THE STUDY

Data and Data sources

The primary sources of the data has been collected by having direct interview with the
branch manager. The secondary data are to be collected from listed securities. All the stocks from
the NSE has been selected. The data required to do calculations has been collected from annual
average return of sample stocks. And the value of listed securities had been collected from
corporate data base. The other theoretical information, facts and figures regarding the growth of
capital markets will be collected from National Stock Exchange official publications. . Extensive
use of books, journals and magazines were made for obtaining required information.

The steps in construction of portfolio using the Sharpe Method are as follows

 Find the excess return to β (beta) ratio


 Arrange the calculated excess return to β share in the descending order.

 Find the cut- off points

Statistical tools used for discussion

Beta coefficient

Beta coefficient measures a stock’s relative volatility. It shows the point of movement of an asset’s
yield in reaction to a variation in the market’s return.

Beta = Covariance (stock price, market index)

Variance (market index)
Return

The aggregate gain or loss experienced on an investment over a given period of time is calculated
through dividing the cash distribution on assets during the period, plus change in value, by its
beginning-of-period investment value is termed as return.

Ri = ((Today’s market price – Yesterday’s market price)/ Yesterday’s market price) *100

Risk-free rate of return (Rf)

Risk-free rate of return is the rate of return of an investment with nil risk, normally 3 month
Treasury bill.

Excess Return-Beta Ratio

Ri-Rf

βi

Where,

Ri= expected return on stock,

Rf = the return on a risk-free asset,

βi= the expected change in rate of return on stock associated with one percent change in the market
return

Cut-off Point
 2

m = variance of the market index

ei = stock’s unsystematic risk

Investment to be made in each Security

Xi=Zi/∑Zi

i=1

Where, Xi= the proportion of investment on each stock.

Zi= βi/ei2 (Ri-Rf/βi-Ci)

Where, Ci= cut-off point

LITERATURE REVIEW


Naveen, (2014) studied “Application of Sharpe Single Index Model to BSE” and the study
revealed that Sharpe gave a road map to construct the optimal portfolio. The lessons show that
cut off price the stage a vital role in constructing the optimal portfolio. The study also states
that investor should continuously observe his portfolio because market situation keeps on
changing
so investor should review his portfolio consequently.


(Kapil Sena and CA Disha Fatawat, 2014) analyzed Sharpe’s Model and its use on constructing
a portfolio. The study discloses that the constructing optimal portfolio using Sharpe’s Single
Index Model is simple and convenient than using Markowitz’s Mean-Variance Model.



UdoImeh (2012), in his article titled, ‘Portfolio Models Analysis: A Review’ has stated the
definition of portfolio analysis which was given by Forbes Group says portfolio analysis is an
efficient method of analyzing the business that makes up an organization portfolio.



Radhika Desai and Manisha Surti (2013) focused on wise investors invest their valued money
in bunch of securities rather investing in a single security because they require to take
advantage of diversification of risk and they want to get maximum return. Bunch of securities
are known as Portfolio and this portfolio must possess minimum risk and maximum return. In
this research they have constructed Sharpe single index optimum portfolio by using data of
fifty companies CNX NSE Nifty index for period of 2010-2012.



P. Varadarajan, Dr.Vikkramanand and J Joshua Selvakumar (2011) in their study entitled
Construction of Portfolio empirically Using Sharpe Index Model with the special Reference to
FMCC Industry in India stated that, one of the finest investment is in the FMCG industry, and
measured five years stock prices (2005 -2009) of 10 companies and constructed optimal
portfolio. This resulted in the weights for better venture in Russal, P&G, Britania and Dabur
with 11.9%, 3.83%, 42.04% and 42.37% correspondingly.



Rene TerHaar (2008), in his article titled ‘Project, program and portfolio management in large
Dutch organizations’ has stated the definition of portfolio management given by office of
Government Commerce(2008,a 2)‘as a coordinated collection of strategic processes and
decisions which facilitate the most effective balance of organizational variation and business
operations.



Shan Rajegopal.(2007), in his book titled, ‘Project Portfolio Management: Leading the
Corporate


Vision’ has define ‘the benefits of portfolio management, inter alia, improved co-ordination
between different departments in an association, together arrangement with organizational
objectives, listed portfolio value with optimal balance, increased transparency and efficient
decision-making, improved source of consumption.’


Thiry M.(2006), in his article titled, ‘Recent developments in project-based 8assistance8ns’
has described portfolio management as ‘the method of analyzing and allocating organizational
resources to programs and projects across the organization on an on continuous basis to achieve
corporate objectives and to maximize value for the stakeholders.’



Harvey Levine (2005), in his article titled, ‘Project Portfolio Management: A useful model To
choose Projects, administration Portfolios and maximize Benefits’ has described portfolio
management ‘as a set of business process which takes the world of projects into close alliance
with other business operations.



Stephen Bonham (2004), in his book titled, ‘Actionable strategies through integrated
performance, process, and project and risk management’ has stated ‘that a ‘Project
Management


Office’ (PMO) audit team should have an input on the prioritizing of the portfolio. A Project
management office team can help an organization to get a hold on the portfolio so that it set
its objectives more efficiently and can achieve them at minor cost. PMO is not only about
managing projects, but also about why, which and how of doing projects.’



Harry Markowitz (1952), in his article titled ‘The Early history of Portfolio Theory: 1600-
1960’ has introduced the concept of efficient portfolio’ ‘as a process which will optimizes the
return of an asset or curtails the risk of an asset for a specified level of return. The concept is
understood by diversifying assets in a portfolio, which is attained by investing in a variety of
different stocks that change differently in relation to each other – stocks with low covariance.

1.8 LIMITATION OF THE STUDY

 Only 15 companies have been taken for the purpose of conducting this study.

 The results from the study may not be applicable universally.

 An optimal portfolio cannot decrease systematic risk which affects the entire market.
Therefore, the return from the portfolio differs with the common trend in the markets.

 The data which used for the calculation doesn’t includes till date prices of the stocks.