Sharpe's Model

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SHARPE’S MODEL – SINGLE

INDEX MODEL
INDEX MODEL
 Markowitz’s approach of model portfolio requires a

considerable amount of calculations; for n
securities portfolio, one need to have (a) n number
of returns (b) n number of variances (c) (n^2 – n)/2
number covariance calculations; in total it requires
n(n+3)/2 number of calculations, which is a
cumbersome task. Markowitz also emphasized
that each security has correlation with another. In
contrast to this, William Sharp was of the opinion
that each security has a perfect link with the
market portfolio or index of the market. Using this
relationship of the security with the single index of
the market, one can estimate characteristic line of
the security as well as can construct efficient
portfolio
INDEX MODEL….contd….
 In contrast the premises of Markowitz’s model,

Sharpe’s model favors that an individual securities has
relationship with one common parameter of the
market, i.e. index of the market. According to Sharpe’s
concept, different securities in the market do not have
any kind of direct relation with each other; instead,
these have a link with the index of the market, which is
representative of the entire market. There are
stocks(shares) in the market, which show an upward
movement as soon as market moves up and vice –
versa. Certain shares in the market have an opposite
relationship with the whole market. This association of
individual securities with the market is through the
stock index of the market
 Stock index (SENSEX) is representative of the

market and every security has a relationship with
this Index. This relationship can help in estimating
and representing the returns of these securities.
Unlike Markowitz, Sharpe does not believe in one
to one relationship of individual securities.
 This association of individual securities with the
index is represented with the help of beta and
depending on the Beta value of the securities,
these get classified into following three types :
 Defensive stock (shares) i.e. beta < 1
 Neutral stock (shares) i.e. beta = 1
 Aggressive stock (shares) i.e. beta >1
Defensive stock – these are the shares that
have beta value less than 1, which implies
that these show a movement in the return at
a slow pace as compared to the movement of
overall market. E.g. if a stock has beta of
0.75 than for every 1% change in the overall
market this will show a movement of 0.75%.
Neutral Stock – these shares have a beta
value of (1) which has an implication that
these have the tendency to make a
movement as good as that of the overall
market.
Aggressive Stocks – such shares have

the beta value more than 1 (beta >1) and
these move at a faster pace then the
movement of the overall market. E.g. if
beta of a share is 1.45, then this will show
a movement of 1.45% for every 1%
movement in the overall index of the
market.
It is the simplification over the modern

portfolio theory given my Harry Markowitz. In
this model, it is favored that returns and risk
of a securities can be represented in the form
of characteristic line, which implies the return
and risk of securities can be bifurcated into
two :

Returns and risk on account of market-wide
factors – Systematic Factors

Returns and risk on account of company-wide
factors Non-Systematic Factors
The model also advocated that an individual

security is desirable only when its returns are
in excess of the risk free returns. The excess
returns of an individual security hold a
relationship with the excess return on the
market portfolio. In the absence of the market
portfolio a representative index can be used
to show this relationship. Returns and risk of
individual securities fluctuate, depending
upon the fluctuation in the market portfolio/
market index. This relationship can be used
to create portfolio.
Original version of william sharpe’s
single index model
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.
single index model…. Contd…..
Following concepts are relevant for the

model
1)Market Portfolio
2)Systematic Risk
3)Non-systematic Risk
4)Residual Error Returns
Market Portfolio – It is a portfolio in which all

the securities of the market find exactly the
same proportion in which these have a
representation in the overall market
capitalization. Portfolio created like this,
represents the movement of whole of the
market and Beta of such market portfolio is
always ‘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.
 Systematic Risk – By systematic risk, we mean the risk

that arises on account of market-wide factors. This risk
can never be eliminated because it is an inherent part of
the market and investment activities. These risk factors
affect all investment avenues. This model assumes that
fluctuations in the value of stock relative to that of another
do not depend on the characteristic 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.
 Non-systematic Risk – This is such component of risk,

which is on account of company-wide factors or factors
specific to a particular investment avenue. This part of the
risk can either be eliminated completely with the help of
diversification.
 Residual Error Returns – By residual error returns, we
mean the returns that arise on account of extraordinary
event concerning the performance of a company. When
these events are favouring the company, the effect is
positive, otherwise it is negative. Residual error returns
are positive when company declares bonus, merger,
diversification or strategic alliance for the better. It will be
negative when a sudden fall in the profits is observed,
restrictions are applied on company or other negative
aspects take place.
Characteristic line
It represents decomposition of risk and return into its

components; it is believed that both of these parameters
of an individual security and portfolio are on account of
two broad factors. Characteristic line can be used to
calculate estimated return of a portfolio or security.
Characteristic line shows the bifurcation of security’s
return (Ri) into the following :
 Market-wide component of return and risk- Systematic
Component
 Company-wide component of return and risk – Non-
systematic – Alpha Component
 Random returns
Graph showing characteristic line
figure 17.1
Undervalued securities or
Return on individual share portfolio
Characteristic
line
Overvalued securities or portfolio

Alpha
Return on Market Portfolio

figure 17.1 contd……
This graph shows characteristic line and

alpha of a security is positive and return
on market portfolio is zero.
 Sometimes Alpha of security is negative
and return on market portfolio is zero; this
relationship has been shown in the next
graph:
figure 17.2
Return on individual share Undervalued shares
Characteristic
line
Overvalued securities or
portfolio
Return on Market Portfolio

Alpha
Characteristic line contd…….
Systematic component of returns is such a

component, which is on account of association
of the security with the general index of the
market and is represented with the help of beta.
Mathematically, it is shown as follows:
Systematic Return = ‾
Systematic Risk = ‾
Non-systematic component ( ) is the

residual return resulting from the
performance of the company. This
changes on account of changes in the
performance of the company.

Residual Return ( ) : ‾ ‾
 Residual Risk =
Random returns are the returns

generated on account of random factors
like mergers, acquisitions, extraordinary
performance etc. Generally, it is
considered zero, due to this, alpha ( ) of
a security can be calculated as residual
returns or residual component of risk.
 Characteristic Line Showing Return

Ri =αi +(βi×Rm ) +ei
Ri = Mean return of the security
αi =Alpha component, i.e., non-systematic return
(residual return)
βi = Beta of the securityi e
Rm = Mean of the market or index representing

the market
ei = Residual error return, which is considered as
'zero'
Using characteristic line, a portfolio manager can
estimate expected return.
Characteristic Line Showing risk :-

σi2 = ( βi2 ×σ m2 ) + σ ei2
σ i
2
= Variance of security's return
βi = Beta of the security
σ m2 = Variance of market or index
σ 2
ei = Non-systematic risk i.e., residual risk
Calculation of Return and Risk of
Portfolio Under Sharpe's Model
Risk-return' and Sharpe Model

The return of each security is represented by the
following equation:
Ri = αi + βi × R m + ei
Ri = Expected return on security
αi = Intercept of straight line or Alpha coefficient
Rm= Expected mean return on market
ei = Random error or error term with mean and
S.D. equal to zero which is a constant.
The mean value of (ei) is zero and hence the
equation becomes-
Ri =αi + βi Rm
Portfolio Under Sharpe's Model contd...
The equation has two coefficients or terms. The

alpha value is the value of (Ri), in the equation
when the value of (Rm) is zero; in other words, it
is part of return which is realized from the security
even if the market 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 a measure of the
sensitivity of .the stock's return to the movement in
the market's return. The combined term (βi Rm )
denote that part of return, which is due to market
movement. This is the systematic component of
the Security's return.
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
β p = Beta of the portfolio is the weighted beta

of the individual securities comprised in the
portfolio.
α p = Value of the Alpha for the portfolio.

Portfolio alpha value is the weighted
average of the Alpha' values for its
component securities, using relative market
value as weight.
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
Systematic Risk = β ×σ
i
2 2
m
Unsystematic risk = Total variance of

security - Systematic risk
Variance of Portfolio
n
σ = β ×σ + ∑Wi ×σ
2
p
2
p
2
m
2 2
ei
i =1
Systematic risk of the portfolio = β ×σ 2

p
2
m
n
Non-systematic risk of portfolio = ∑W
i =1
i
2
×σ 2
ei
Construction of Efficient Portfolio
 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:
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.
contd…
If securities are ranked by excess return to

Beta (from highest to lowest) the ranking
represents the desirability of any security's
inclusion in a portfolio.
The number of securities selected,
depends on a unique cut-off point, such that
all securities with higher ratio of
(Ri - Rf)/Beta i, will be included in the
portfolio and all securities with lower ratio will
not be included in the portfolio. To determine
which securities are included in the optimum
portfolio, the following steps are necessary.
contd…
 Steps for Creating Efficient Portfolio:
I. Calculate the excess return. to beta ratio for each
security.
2. Review and rank from highest to lowest excess return
to beta ratio
3. The optimum portfolio consists of investing in all the
securities, for which excess return to beta ratio
[(Ri- Rf)/Beta i] is greater than the overall cut-off
point c*.
The value of c* is the overall cut-off point It is the
cut-off point of the last security included in the
portfolio. It is computed from the characteristics of all
the securities that belong to optimum portfolio. To
determine c*, it is necessary to calculate its value as if
there were different numbers of securities in the
optimum portfolio.
contd…
Since securities are ranked from highest "Excess

return to beta" to lowest, securities with individual
cut-off point more than c* are eligible to be
included in the portfolio. All the securities, which
have excess return to beta ratio more than the
overall cut-off point are included in the portfolio.
Such portfolio is the efficient portfolio and
generates the optimum return for the risk
category.
For a portfolio of i securities, cut-off point (ci) for
each security is calculated as follows:
contd…
n {( Ri − R f ) / βi }
σ × ∑[
2
]
m
i =1 σ 2
Cutoff Rate (ci ) = ei
βn2
1 +σm × ∑ i2
2
i =1 σei
contd…
To construct the best portfolio, the

proportion of funds invested in each
selected security in the optimum portfolio
is to be calculated, using the following
formula:
Zi
Wi =
∑Z i
βi Ri − R f
Z i = 2 ×[{ } −c ]
*
σei βi
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
The original work of William Sharpe insisted on only two

components of return and risk - systematic and nonsystematic
components. At a later stage, few thinkers and portfolio
planners have amended the components of return and risk at
the time of representing these in the form of characteristic
line. These thinkers are of the view that total return of an
individual security as well as that of a portfolio can first be
represented as excess return over risk-free rate of return and
then this excess return can further be divided into two -
systematic component of excess return and nonsystematic
component of excess return. Accordingly, following concepts
are relevant in the modified model:
1. Concept of Risk-free Return and Excess Return
2. Market Portfolio
3. Systematic Risk
4. Non-systematic Risk
5. Residual Error Returns
Subsequent Modification in the Model by
Considering Risk-Free Return contd…
I. Concept of Risk-free Return and Excess

Return
Sharpe's model advocates that an individual share
is desirable for investment only when it has
average/mean returns more than the risk-free return;
this is preferred by investors because investment in
individual shares entails certain degree of risk and
investors need extra returns to compensate for the
risk. Accordingly, the model assumes that prima-facie
selection of securities in a portfolio completely
depends on the amount of excess return over the risk
free returns. This concept of excess return is also
relevant in representing the characteristic line
representing returns of an individual share.
Characteristic line is a way to represent excess

return of the security as originating from non-
systematic factors and systematic factor. The
excess return of an individual security are
generated on account of the company's
performance and the association of the share with
the market portfolio or representative index of the
market, respectively called non-systematic
component part of the excess return and
systematic component of the excess return.
Accordingly, mean return of an individual share
are represented as follows:
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
R m = Mean of the market or index representing the
market
ei = Residual error return, which is considered as
'zero'
 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.
 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.
 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.
 5. Residual Error Returns

By residual error returns, we mean those returns
which arise on account of extraordinary event
concerning the performance of a company. When
these events are favouring the company, the effect
is positive; otherwise it is negative. Residual error
returns are positive when company declares
bonus, merger, diversification or strategic alliance
for the better. It will be negative when a sudden
fall in the profits is observed, restriction are
applied on company or other negative aspects
take place.
Characteristic Line
 It represents decomposition of risk and return into its

components, it is believed that both these parameters of
an individual security and portfolio are on account of two
broad factor, i.e. systematic factor affecting the whole of
the economy and market and another set of factors
related to the company itself called as non-systematic
factors. Returns on account of both of these factors is
called excess return. This excess return when
represented in these two segments, is called
characteristic line of the security. The characteristic line
developed on the basis of historical data is helpful in
predicting the returns of an individual share, given the
excess return on the market portfolio/index of the
market. The characteristic line so developed, can be
used to calculate estimated return of a portfolio.
Characteristic line contd….
Characteristic line shows the bifurcation of security’s excess return
into
R i −the
R ffollowing:
(a)Market wide component of return and risk – Systematic
Component
(b) Company wide component of return and risk i.e. , Non-
Systematic- Alpha Component
(c) Random returns always considered to be zero
Systematic component of excess return is such component which
is on account of association of the security with the general index
of the market and it is represented with the help of beta.
Mathematically it is shown as follows
Systematic Return =
βi × ( R m − R f )
Systematic Risk =
βi2 ×Var ( R m − R f )
Non-systematic component (alpha i) is the residual part of the

excess return resulting from the performance of the company.
This changes on account of changes in the performance of
the company as well as on account of the factors solely
affecting the performance of the company.
Residual Return
α i = ( R i − R f ) − β i × ( R m − R f ) + ei
here ei is the random error of the returns, always considered to
be zero
Residual Risk = σ i
2
− β i × Var ( R m − R f )
2
Random returns are returns which are generated on account of

random factors like merger, acquisition, extraordinary
performance, etc. generally it is considered zero, due to this
alpha(alpha i) of the security can be calculated as residual
return or residual components of risk.
 Characteristic line Showing Return

R i − R f = α i + β i × ( R m − R f ) + ei
R i= Mean return of the security
= Risk free return
R f = Alpha components of excess returns, i.e. non-systematic return(
α iresidual return)
= Beta of the security
βi= Mean of the market or index representing the market
R m= Residual error return which is considered as ‘zero’
eUsing
i
characteristic line a portfolio manager can estimate
expected return
Characteristic Line Showing Risk

σ i2 = β i2 × Var( R m − R f ) + σ ei2
σ i2 = Variance of security’s excess return
σ m2 = variance of the market or index = Var R m − R f
σ ei2 = Non-systematic risk, i.e. residual risk
Calculation of return and Risk of the
Portfolio Under Sharpe’s Model
 Risk-Return and Sharpe Model

The return of each security is represented by the following
equation:
R i − R f = α i + β i × ( R m − R f ) + ei
R i − R f = Mean excess return of the security
R f = Risk free return
αi = Intercept of straight line or Alpha coefficient it such amount
of excess return when excess return on the market portfolio is
zero.
R m = Expected mean return on market
ei = Random error or error term with mean of zero and S.D.
which is a constant.
The mean value of ei is zero and hence the equation becomes
Portfolio Under Sharpe’s Model 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.
 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
R f = Risk free return

Wi = The proportion of the portfolio devoted to stock i
n
βp = ∑Wi βi
i =1
β p = Beta of the portfolio is weighted beta of the individual

securities comprised in the portfolio.
n
αp = ∑Wiαi
i =1
α p = Value of the alpha for the portfolio. Portfolio alpha

value is the weighted average of the alpha values for
its component securities, using relative market value
as weight.
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 R i = Variance of Security’s excess

return
σ ei2 = Unsystematic risk of security I

β
Systematic Risk = i ×Var ( R m − R f )
2
Unsystematic Risk = Total variance of security –

Systematic risk
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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Welcome to Unitedworld

SHARPE’S MODEL – SINGLE

 Markowitz’s approach of model portfolio requires a

 In contrast the premises of Markowitz’s model,

 Stock index (SENSEX) is representative of the

Aggressive Stocks – such shares have

It is the simplification over the modern

The model also advocated that an individual

Following concepts are relevant for the

Market Portfolio – It is a portfolio in which all

 Systematic Risk – By systematic risk, we mean the risk

 Non-systematic Risk – This is such component of risk,

It represents decomposition of risk and return into its

Overvalued securities or portfolio

Return on Market Portfolio

This graph shows characteristic line and

Return on individual share Undervalued shares

Return on Market Portfolio

Systematic component of returns is such a

Non-systematic component ( ) is the

Random returns are the returns

 Characteristic Line Showing Return

Rm = Mean of the market or index representing

Characteristic Line Showing risk :-

Risk-return' and Sharpe Model

The equation has two coefficients or terms. The

β p = Beta of the portfolio is the weighted beta

α p = Value of the Alpha for the portfolio.

Unsystematic risk = Total variance of

Systematic risk of the portfolio = β ×σ 2

If securities are ranked by excess return to

Since securities are ranked from highest "Excess

To construct the best portfolio, the

The original work of William Sharpe insisted on only two

I. Concept of Risk-free Return and Excess

Characteristic line is a way to represent excess

 5. Residual Error Returns

 It represents decomposition of risk and return into its

Non-systematic component (alpha i) is the residual part of the

Random returns are returns which are generated on account of

 Characteristic line Showing Return

Characteristic Line Showing Risk

 Risk-Return and Sharpe Model

R f = Risk free return

β p = Beta of the portfolio is weighted beta of the individual

α p = Value of the alpha for the portfolio. Portfolio alpha

Variance R i = Variance of Security’s excess

σ ei2 = Unsystematic risk of security I

Unsystematic Risk = Total variance of security –

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