Sharpe's Single Index Model 1.

Introduction

Single index model advocates that individual securities do not hold any kind of direct relationship with each other. Instead, these have a relationship with market portfolio or a single index (sensex) which represents the whole market. This is quite different from Markowitz model which advocates the existence of direct relationship between individual securities. Single index model addresses the problem of calculation of large number of expected returns, variances and covariances (as required in Markowitz model) on the assumption that movement between stocks is due to single common index and there is no correlation between the return on any two securities. Thus it obviates the need for so many covariances and thus makes portfolio analysis a manageable task. For example- if an analyst is considering 100 securities, the Markowitz model requires 100 expected returns, 100 variance terms and 4950 covariances. But as per Single Index model, all the 100 securities can be linked to single index portfolio and thus better managed.

2.

The model

Following three formulae form the bedrock of the single index model: I. Where, I. where, is the variance of security a a is the sensitivity of security a to the market is the variance of return on the market index eA is the standard deviation of the error term Ra is the expected return on security a a is the value of independent return of security a a is the sensitivity of security a to the market Rm is the retun on the market index eA is the error term Risk or variance Return

I.

Covariance between two securities

Covariance between two securities a and b is given by: where', Covar.ab is the covariance of returns of security a and security b a is the sensitivity of security a to the market b is the sensitivity of security b to the market is the variance of return on the market index Thus covariance between any two securities can be calculated from the beta of the two securities and the standard deviation of the returns on the market index. The data requirements for the above calculations are: For each security: alpha( betaand std. error (e) For the market: Rm (market return on security) and m (std. Deviation of market return) Illustration: Suppose, returns in the market over a 6 month period were +3%, +2%, +1%, -1%, -2% and -3% for security a. If the of the security is 1.5% and its is 2, find out the expected returns on the security. Solution:
Month Market returns (Rm) Beta (Rm x

Expected returns
(Rm x

Actual returns 7.6% 5.6% 3.0% -0.7% -2.3% -4.2%

Error

1 2 3 4 5 6 Total
Variance S.D.

3.0% 2.0% 1.0% -1.0% -2.0% -3.0% 0.0%

2 2 2 2 2 2

6.0% 4.0% 2.0% -2.0% -4.0% -6.0%

1.5% 1.5% 1.5% 1.5% 1.5% 1.5%

7.5% 5.5.% 3.5% -0.5% -2.5% -4.5%

0.1% 0.1% -0.5% -0.2% 0.2% 0.3% 0.0%

5.6% 2.4%

0.088% 0.3%

1.

Variance of security a: =

= 0.22488%
2. Covariance of security a with security b which has of 1.25: = Under single index model alpha () and beta ()of any portfolio can be calculated on the basis of 2

weight of individual securities in the portfolio. For example- a portfolio comprised of two securities X and Y in the ratio of 2:3. Values of and of both securities are given as under. Find out values of and of the portfolio. Security X Weight 40% 0.01 1.2 Security Y 60% 0.02 1.5 (0.01x40%)+(0.02x60%) = 0.016 (1.2x40%)+(1.5x60%) = 1.380 Portfolio