You are on page 1of 9
In this section, we will learn how to select the optimum portfolio using the Sharpe optimization model.First we present the ranking criteria that can be used to order the stocks for selection of the optimum portfolio. Next we present the technique for employing this ranking device to form an optimum portfolio. The Formation of Optimal Portfolios The construction of the optimal portfolio would be greatly facilitated, and the ability of the portfoliomanagers and security analysts to relate to the construction of the optimum portfolios greatlysimplified if a single number measures the desirability of including the stock in the optimum portfolio.If any person is willing to accept the standard form of the single-index model as describing the co-movement between the securities the justification of any stock in the optimum portfolio is directlyrelated to its excess return-to-beta ratio. Excess return is the difference between the expected return onthe stock and the risk-free rate of interest such as rate of return on the government securities. Theexcess return-to-beta ratio measures the additional return on a stock (excess return over the risk-freerate) per unit of non-diversifiable risk. This ratio gels an easy interpretation and acceptance by securityanalysts and portfolio managers, because they are interested to think in terms of the relationship between potential rewards and risk. The numerator of this ratio of excess return-to-beta contains theextra return over the risk-free rate. The denominator is the measurement of the non-diversifiable risk that we are subject to by holding risky assets rather than riskless assets. 100 10049501000 1000499500We can see that when the number of securities in a portfolio is equal to 100, the number of covarianceterms are 4,950 whereas the number of variance terms are only 100. This huge number of covarianceterm suggests that portfolio risk will be immensely attributable to covariance factor rather thanvariance factor.We can rewrite the equation 7.3 in the following format:Var(R p )= ∑∑ == n1in1 j W j W j ρ ij SD(R j ) SD(R j ) ...Eq. (C)Above equation represents both the variance and the covariances of the securities, because when i = j,the variances will be accounted whereas, if i ≠ j the covariances can be calculated. If we want to usethe above equation, we need to calculate the variance of each security and correlation coefficients or covariances. We can calculate both covariance and the correlation coefficient using either ex, post or ex ante data. If the historical data is good estimate of the future value then, it can be used for calculating the portfolio risk. However, it must be remembered that the variance and correlationcoefficients can change over time. Our discussion on the portfolio risk can be concluded byhighlighting the following:1. The measurement of portfolio risk requires information regarding the variance of individualsecurities and the covariance between the securities. 2. Three factors determine any portfolio risk: variances of the individual securities, the covariances between the pairs of the securities and the proportions of total fund invested in securities.3. As the number of the securities increase in a portfolio, the impact of the covariance of the securitesrather than their individual variance, affects the portfolio risk. Systematic and Unsystematic Risk In our earlier sections, we discussed that the variance of the portfolio is measure of its risk. Accordingto the portfolio theory, the total risk (variance) is not the relevant risk in the portfolio context. It isnecessary to understand that the risk of security when held in isolation is not equal to the amount of risk it contributes to a portfolio, when it is included in the portfolio. We are aware that the risk of asecurity is the sum of systematic risk and unsystematic risk. Unsystematic risk is the extent of variability in the security's return due to the specific risk attached to the firm of that particular security.Unsystematic risk is diversifiable risk, and hence this risk can be removed from the total risk of portfolio by investing in large portfolio securities. This is possible, because the firm specific risk factors are mostly random. For example, if the financial position of one company is weak, thefinancial health of the other company in the portfolio can be strong enough to neutralize the risk attributed by the weak financial position of the firm. However, the systematic or nondiversifiable risk cannot be diversified away completely because it depends on the factors affecting the whole market ina particular direction. For example, a steep rise in inflation in India will affect the entire marketadversely and therefore, no diversification can make a portfolio free from this risk. Since thesystematic risk affects the entire market, it is also known as the market risk.We know that total risk of security is measured in terms of the variance or standard deviation of itsreturns. We also know that total risk consists of systematic and unsystematic risk. We will now try tosegregate these two risks.Total risk of a security i = 2i σ 70 Systematic risk of security i = 2m2im σβ Where, im β is the beta of the security i and 2m σ is the variance of the market portfolio.But,Substituting the value for 2mim2mimi Cov σ=σσ=β in the above equation, we getSystematic risk of security i = 2m2im2m4m2im CovxCov σ As we know from the relation between covariance and correlation, the above equation can be writtenin the following form:Since Cov im = miim σσρ Systematic risk of security i = 2i2im2m2m2i2im σρ=σσσρ = 2i2im R σ since 2im2im R ρ= Where, 2im ρ is the correlation coefficient, and 2im R is the coefficient of determination between the security i and the market portfolio. From theabove equation, it is evident that coefficient of determination is ( 2im R ) the indicator of the systematicrisk. The coefficient of determination indicates the percentage of the variance explained by thevariationof return on the market index. To calculate the systematic risk of the portfolio, we should add thesystematic risk of the individual securities.Systematic Risk of the Portfolio = 2m2n1iimi X β ∑ = Unsystematic risk of the security is the difference between the total risk and the systematic risk of the 71 security and can be represented in the following form:Unsystematic Risk 2m2im2i2ei σβ−σ=σ or, = 2i2im2i σρ−σ = ( 2im2i 1 ρ−σ = 2im2i R1 −σ Unsystematic risk of the security is the percentage of the variance of the security's return not explained by the variance of return on the market index. This unexplained variance is also called the residualvariance of the security. Unsystematic risk of a portfolio can be calculated as the total unsystematicrisk of the individual security forming that portfolio.Unsystematic risk of portfolio = ∑ = σ n1i2ei2i X Total portfolio variance can be represented as σβ=σ ∑∑ == n1i2ei2in1i2m2imi2p X)X( --(6.6)Where, 2p σ = Variance of portfolio return 2m σ = Expected variance of index 2ei σ = Variance in security not caused by its relationship to the indexX i = Proportion of the total portfolio invested in security in = Total number of stocks