The Sharpe Index Model

HARI PRAPAN SHARMA

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