SINGLE INDEX MODEL

Ri = i + i Rm +ei
Ri expected return on security i
i intercept of the straight line or alpha co efficient
i slope of straight line or beta co efficient
Rm the rate of return on market index
Ei error term
 Ri = i + iRm + ei
The variance of securitys return, 2 = i 2m + 2ei
Covariance of returns securities i and j is
ij = i j + 2m

The variance of the security has two components namely, systematic risk or
market risk and unsystematic risk or unique risk. The variance explained by
the index is referred to systematic risk. The unexplained variance is called
residual variance or unsystematic risk.
Systematic risk = 2i x variance of market index.
= 2 i 2 m .
Unsystematic risk = Total variance Systematic risk.
e2i = 2i systematic risk
Thus, the total risk = Systematic + Unsystematic risk.
From this the portfolio variance can be derived.

N N
2p = (xi i )2 2m + x2i e2i
i=1 i=1

2p = variance of portfolio

2m = expected variance of index

e2i = variance in securitys return not related to market

index

ei = the portion of stock i in the portfolio

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

N
Rp = xi ( i + i Rm)
i=1
 N
p = x
i=1 i i

p - Value of the alpha for the portfolio

xi - Proportion of the investment on security i
i - Value of alpha for security i
p Portfolio Beta
N The number of securities in the portfolio
Similarly, a portfolios beta is the weighted average of
the beta values of its component stocks using relative
share of them in the portfolio as weights.
N
p = i = 1xi i
CORNER PORTFOLIO

Rp

R B
2
6
9
14

15
A
0 p
S
 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 riskless asset
i = the expected change in the return on stock i
associated with one unit change in the market return
The steps for finding out the stocks to be included
in the optimal portfolio are given below :
1. Find out the excess return to beta ratio for each
stock under consideration.
2. Rank them from the highest to the lowest.
3. Proceed to calculate Ci for all the stocks according
to the ranked order using the following formula.
N (Ri Rf )i
m
2
2ei
i=1
Ci =
N i2
1+2m i = 1 ei
2

2m = variance of the market index

2 ei = unsystematic risk of stock
 The Ci can be stated with mathematically equivalent way.

ip (Rp Rf )
Ci =
i
ip the expected change in the rate of return on stock I
associated with 1 per cent change in the return on the
portfolio.
Rp the expected return on the optimal portfolio
Ri Rf
> Ci
i
The above equation can be rearranged with the substitution of equation :

ip (Rp Rf )
Ci =
i
Now we have,
Ri Rf > ip (Rp Rf )
OPTIMUM PORTFOLIO WITH SHORT SALES

Zi
Xi = N
Zi
i=1

i Ri Rf
Zi = 2 C
ei i
 CONCLUSION :

1. The sharp model is based on the securitys

return relationship with the index return. Beta
is the deciding factor in measuring the
systematic risk.
2. The systematic and unsystematic can be
computed with the Sharp model.
3. Using the Sharp model, portfolio return and
risk can be computes easily, compared to
Markowitz model.