Finance

Constructing an optimal portfolio using Sharpes single index model

Debasish Dutt

This paper attempts to construct an optimal portfolio by applying Sharpes Single Index Model of Capital Asset Pricing. Taking BSE 100 as market index and considering daily indices for the Oct02-April 03 period, the proposed method formulates a unique cut off point (Cut off rate of return) and selects stocks having excess of their expected return over risk-free rate of return surpassing this cut-off point. Percentage of investment in each of the selected stocks is then decided on the basis of respective weights assigned to each stock depending on respective value, stock movement variance representing unsystematic risk, return on stock and risk free return vis-a-vis the cut off rate off return. Interestingly all the stocks selected turn out to be bank stocks.

he foundation of Modern Port folio Theory was laid by Markowitz in 1951. He began with the simple premise that since almost all investors invest in multiple securities rather than one, there must be some benefit in investing in a portfolio of securities. He measured riskiness of a portfolio through variability of returns and showed that investment in several securities reduced this risk. His work won him the Nobel prize for Economics in 1990. Markowitzs work was extended by Sharpe in 1964, Lintner in 1965 and Mossin in 1966. Sharpe shared the Nobel prize for Economics in 1990 with Markowitz and Miller for his contribution to the Capital Asset Pricing Model (CAPM). This model breaks up the riskiness of each security into two components - the market related risk which cannot be diversified called systematic risk measured by the beta coefficient and another component which can be eliminated through diversification called unsysAICWA & Jt. General Manager, Simplex Concrete Piles (India) Ltd.

tematic risk. Single Index Model The Markowitz model is extremely demanding in its data needs for generating the desired efficient portfolio. It requires N(N+3)/2 estimates (N expected returns + N variances of returns + N*(N-1 )/2 unique covariances of returns). Because of this limitation the single index model with less input data requirements has emerged. The Single index model requires 3N+2 estimates (estimates of alpha for each stock, estimates of beta for each stock, estimates of variance ei 2 for each stock, estimate for expected return on market index and an estimate of the variance of returns on the market index m2) to use the Markowitz optimization framework. The single index model assumes that co-movement between stocks is due to movement in the index. The basic equation underlying the single index model is: Ri = ai + *Rm where Ri = Return on the ith stock

ai = component of security is that is independent of market performance = coefficient that measures expected change in Ri given a change in Rm Rm = rate of return on market index The term ai in the above equation is usually broken down into two elements a i which is the expected value of ai and ei which is the random element of ai The single index model equation, therefore, becomes: Ri= i + Rm + ei Single index model has been criticized because of its assumption that stock prices move together only because of common co-movement with the market. Many researchers have found that there are influences beyond the market, like industry-related factors, that cause securities to move together. Empirical evidence, however, reveal that the more complex models have not been able to consistently outperform the single index model in terms of their ability to predict ex-ante (fu-

Finance ture) co-variances between stock returns. Constructing an optimal portfolio - Methodology and analysis BSE 100 has been taken as the market index and daily index figures for the period October 1, 2001 to April 30, 2003 have been obtained from www.bseindia.com. Risk free return has been taken to be the bank rate at 6% p.a. Daily prices of 31 stocks from October 1, 2001 to April 30, 2003 have been taken from www.bseindia.com/www.riskcontrol.com Only those stocks with returns greater than the risk free rate of return and with positive beta have been selected. The expected return, variance, correlation with the market, unsystematic risk, the intercept and the beta for all the 31 stocks have been calculated below: Market index BSE 100 Sl no 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Exp Ret 0.90 -1.77 1.19 3.94 -1.89 4.28 1.45 4.17 0.91 2.02 7.17 4.02 9.70 13.64 7.22 2.62 1.19 0.32 2.57 2.99 3.13 3.76 0.26 3.20 4.29 6.01 8.42 3.10 11.17 6.06 6.03 Variance 27.17 45.83 67.92 266.40 34.40 249.41 18.44 750.60 57.85 46.10 422.33 83.07 177.29 137.92 150.98 150.94 143.34 22.58 130.08 106.53 75.37 349.97 78.22 86.97 78.06 186.16 148.61 55.09 227.23 153.11 142.18 Corr with Unsyst mkt risk Alpha Beta 0.16 0.71 0.82 0.73 0.43 0.38 0.65 0.65 0.54 0.48 0.32 0.47 0.61 0.78 0.01 0.50 0.61 0.63 0.27 0.70 0.39 0.25 0.49 0.35 0.61 0.70 0.03 0.40 0.01 0.58 0.56 0.72 23.14 45.27 140.77 6.40 36.28 7.73 320.75 17.03 10.48 44.08 18.73 96.76 258.85 0.03 37.86 53.09 8.99 9.23 52.89 11.54 22.07 19.06 10.64 29.27 90.69 0.10 8.88 0.02 51.36 45.19 0.76 -2.79 -0.54 0.36 -2.74 2.51 0.91 1.41 0.27 1.52 5.26 3.35 11.25 17.09 7.20 1.26 0.07 -0.14 2.10 1.87 2.49 1.82 -0.42 2.63 3.05 3.89 8.47 2.54 11.17 4.34 4.30 0.14 0.80 1.12 1.98 0.42 1.01 0.46 2.99 0.69 0.54 1.11 0.72 1.64 2.69 0.03 1.03 1.22 0.50 0.51 1.22 0.57 0.78 0.73 0.55 0.90 1.59 0.05 0.50 0.02 1.20 1.12 From the above table it can be seen that a few stocks gave negative returns. This could be due to a host of reasons including bear hammering in a sluggish secondary market. As the criteria for selection mentioned above ignores stocks with negative returns, stocks with negative returns have been ignored. The Sharpe model will automatically exclude such stocks as its ranking is based on excess returns (returns greater than risk free rate of return). As can be seen from the above table, nine of the thirty one stocks have expected returns higher than the risk free rate of return. For determining which of these stocks will be included in the optimal portfolio it is necessary to rank the stocks from highest to lowest based on excess return to beta ratio. (Table 1) The next step is to determine the stocks for which the excess return to beta ratio is higher than a particular unique cutoff point C*. The value of the cutoff rate C* is given by: m2(Ri Rf)i Ci = 1 + m2i2/ei2 where: m2 = variance in the market index ei2 = variance of a stocks movement that is not associated with the movement of the market index: this is the stocks unsystematic risk (Table 2) From table - 2 it can be seen that the first five securities have C values exceeding the corresponding (Ri Rf)/ value. The cutoff rate C* is C5 or 2.037912 and only the top five securities make it to the optimal portfolio. Once the composition of the optimal portfolio is known, the next step is to calculate the percentage to be invested in each security which is given by : Xi0 = Z i/ Zi where Zi = i (Ri Rf C*) i ei2

Stock Name HDFC Bank Hind Lever Reliance Ind Infosys Tech Cipla ICICI Bank BSES NIIT ITC Grasim Ind IPCL BHEL Punjab National Bank Canara Oriental Bank of Commerce Balrampur Chini Mills Hero Honda Motors Britannia Industries Glaxo Smithkline Pharma Tata Tea SKF Bearing (India) Simplex Concrete Piles Dr Reddys Labs Ranbaxy Laboratories TISCO TELCO Andhra Bank State Bank of India Union Bank Bank of Baroda Bank of India

Finance Table - 1 Ranking of stocks based on Excess Return to Beta (Ri-Rf)/ Risk Free Return R f = Bank Rate = 6% p.a. SI. Excess Unsys No. Stock Name Mean Return Return Beta Risk Ri 1 2 3 4 5 6 7 8 9 Union Bank Andhra Bank Oriental Bank of Commerce Canara Punjab Nat Bk IPCL Bank of Baroda Bank of India TELCO 11.16641436 8.42411783 7.22201304 13.64467454 9.70133786 7.16545603 605947092 6.02641804 6.00977156 RiRf 5.166414359 2424117827 0.0235838 0.0528228 ei2 The second expression determines the relative investment in each security, and the first expression simply scales the weights on each security so that they sum to 1. The residual variance ei 2 plays an important role in determining how much to invest in each security. (Table - 3) Findings The optimum portfolio can be broken down into two parts viz the stocks that it comprises and the percentage of funds that go to acquire such stocks. The composition of the optimum portfolio would be : 85.78% of funds invested in Canara Bank stock 11.61% of funds invested in Punjab National Bank stock 1.39% of funds invested in Andhra Bank stock 0.87% of funds invested in Union Bank stock and 0.35% of funds invested in Oriental Bank of Commerce stock The expected return on the portfolio is the sum of the expected returns of the individual stocks which works out to 13.07. The portfolio return is higher than the expected returns of the individual stocks in the portfolio with the exception of Canara Bank Expected return on Portfolio Sl Expected % Stock Name No. Ret invested E w Ew 1 Union Bank 11.17 0.01 0.10 2 Andhra Bank 8.42 0.01 0.12 3 Oriental Bank 7.22 0.00 0.03 of Commerce 4 Canara Bank 13.64 0.86 11.70 5 Punjab Nat Bank 9.70 0.12 1.13 Expected return on portfolio 13.07

Excess Ret to beta (RiRf)/

227.20553 219.0666346 148.51134 45.8915484 150.95836 45.6770758 120.92710 28436851 80.52755 2.2519578 378.25109 1.0505672 51.35761 0.0496645 45.19363 0.0235183 90.69148 0.0061408

1.222013045 0.0267533 7.644674541 2.6882986 3.701337858 1.6436089 1.165456034 1.1093588 0.059470924 1.1974527 0.026418036 1.1232969 0.009771557 1.5912529

Table - 2 Calculations for determining cut off rate Variance of market (m2 ) = 35.82 SI. No. Stock Name Excess ret Unsyst to beta risk (Ri-Rf) 1 Union Bank 2 Andhra Bank 3 Oriental Bank of Commerce 4 Canara 5 Punjab Nat Bk 6 IPCL 7 Bank of Baroda 8 Bank of India 9 TELCO Optimal Portfolio SI. No. 1 2 3 Stock Name Union Bank Andhra Bank Oriental Bank of Commerce 4 Canara Bank 5 Punjab National Bank TOTAL 2/ie2 0.000002 0.000019 (Ri-Rf)/ 219.066635 45.8915484 Z=2/el2(Ri-Rf)/)% C C invested 0.0192058 0.000536223 0.867079 % 0.0500513 0.000861274 1.392691 % 0.000216295 0.349752 % 0.053048034 85.779372 % 0.007180588 11.611106 % 0.061842413 100.00000 % ei2 (RiRf)* /el2 2/el2

(RiRf)* /el2 2/el2

219.07 227.21 0.000536 0.000002 0.000536 0.000002 0.019206 45.89 148.51 0.000862 0.000019 0.001398 0.000021 0.050051 45.68 2.84 2.25 1.05 0.05 0.02 0.01 150.96 120.93 80.53 378.25 101.76 96.98 95.47 0.000217 0.169947 0.075546 0.003418 0.000700 0.000306 0.100170 Table - 3 0.000005 0.059763 0.033547 0.003254 0.014091 0.013010 0.026523 0.001615 0.171562 0.247108 0.250526 0.251226 0.251532 0.351702 0.000026 0.059789 0.093336 0.096589 0.110681 0.123691 0.150214 0.057792 1.956043 2.037912 2.012111 1.812590 1.659064 1.974372

0.000005 45.6770758 0.0577924 0.059763 2.84368509 1.9560429 0.033547 2.251957779 2.03791157

Finance For calculating the portfolio variance it is necessary to find the covariance between individual stocks. Format of 5 security Convariance Matrix w1212 w1w2 cov (1,2) w1w3 cov(1,3) w1w4 cov(1,4) w1w5 cov (1,5) w1w2 cov(1,2) w2222 w3w2 cov(3,2) w4w2 cov(4,2) w5w2 cov(5,2) w1w3 cov(1,3) w2w3 cov(2,3) w3232 w4w3 cov(4,3) w5w3 cov(5,3) w1w4 cov(1,4) w2w4 cov(2,4) w3w4 cov(3,4) w4242 w5w4 cov(5,4) w1w5 cov(1,5) w2w5 cov(2,5) w3w5 cov(3,5) w4w5 cov(4,5) w5252

Disinvestment

Based on the above format the covariance matrix of the five securities in the optimal portfolio works out as under: Convariance Matrix of Stocks in Optimal Portfolio 0.02 0.02 0.00 0.34 0.05 0.02 0.03 0.00 0.80 0.14 0.00 0.00 0.00 0.10 0.04 0.34 0.80 0.10 101.48 5.51 0.05 0.14 0.04 5.51 2.39

The portfolio variance which is the sum of all the covariance entries in the above table works out to 9.05. The portfolio variance is substantially lower than the variances of any of the individual stocks in the portfolio. Bibliography Books 1 Donald E. Fischer, Ronaki J.Jordan Security Analysis and Portfolio Management 2 Edwin J. Elton and Martin J. Gruber Modern Portfolio Theory and Investment Analysis 3 M. Obaidullah Indian Stock Market - Theories and Evidence 4 Prasanna Chandra The Investment Game - How to win 5 Samir K. Barua, J .R. Varma and V.Raghunathan Portfolio Management 6 Zvi Bodie, Alex Kane and Alan J. Marcus Investments Articles Debasish Dutt Valuation of common stock -an overview The Management Accountant November 1998 Web Sites www.bseindia.com www.moneycontrol.com