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The document discusses the Sharpe Index Model for portfolio optimization. It describes how the Sharpe Model estimates systematic and unsystematic risk using beta coefficients that measure the relationship between individual securities and the market index. This allows building an optimal portfolio by selecting securities based on their excess return-beta ratio, ranked from highest to lowest. The portfolio variance is calculated as the weighted sum of the systematic risk and unsystematic risk of its component securities.
The document discusses the Sharpe Index Model for portfolio optimization. It describes how the Sharpe Model estimates systematic and unsystematic risk using beta coefficients that measure the relationship between individual securities and the market index. This allows building an optimal portfolio by selecting securities based on their excess return-beta ratio, ranked from highest to lowest. The portfolio variance is calculated as the weighted sum of the systematic risk and unsystematic risk of its component securities.
The document discusses the Sharpe Index Model for portfolio optimization. It describes how the Sharpe Model estimates systematic and unsystematic risk using beta coefficients that measure the relationship between individual securities and the market index. This allows building an optimal portfolio by selecting securities based on their excess return-beta ratio, ranked from highest to lowest. The portfolio variance is calculated as the weighted sum of the systematic risk and unsystematic risk of its component securities.
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 2 N)/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. Stock prices are related to the market index and this relationship could be used to estimate the return of stock. R i = o i + | i R m + e i where R i expected return on security i o i intercept of the straight line or alpha co- efficient | i slope of straight line or beta co-efficient R m the rate of return on market index e i error term Systematic risk = | i 2 variance of market index = | i 2 o m 2 variance explained by the index Unsystematic risk = Total variance Systematic risk e i 2 = o i 2 Systematic risk ( unexplained variance) Thus the total risk = Systematic risk + Unsystematic risk = | i 2 o m 2 + e i 2 Variance of the security has two component namely systematic risk & unsystematic risk. 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 For each security o i and | 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 )
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.
| p is the portfolio beta. N p i i i =1 = x | |
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 | 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
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 Proceed to calculate C i for all the stocks according to the ranked order using the following formula
o m 2 = variance of the market index o 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. N 2 i f i m 2 i =1 ei i 2 N 2 i m 2 i =1 ei (R R )
1+
By now, you should have:
Understood the Sharpe Index model Been able to calculate systematic and unsystematic risk Understood the concept of optimal portfolio