Also

called the market model It assumes that co-movement between stocks is due to movement in the index.

The

model assumes that the rates of return on securities are related only through their common relationships with some basic underlying factor.

Ri =
The

iI

+ ei

return on any stock depends upon some constant ( ), plus some coefficient ( ), times the value of a stock index (I), plus a random component (e).

index model divides return into two components 1. a unique part, i 2. a market-related part, iI The unique part is a micro event, affecting an individual company The market related part is a macro event that is broad based and affects all (or most) of the firms. The error term ei captures the difference between the return that actually occurs and return expected to occur given a market index return.
Single

Beta

represents the sensitivity of security return to the market index. It measures the co-movement in returns between the market and the security over a given period of time.

 Beta

measures a stocks market (or systematic) risk i.e. it measures the part of the asset's statistical variance that cannot be removed by the diversification.

=1 >1 <1 =0

STOCK HAS AVERAGE RISK STOCK IS RISKIER THAN AVERAGE STOCK IS LESS RISKY THAN AVERAGE RISK FREE ASSETS (E.G., TREASURY BILLS)

total risk of a security is measured by its variance consists of two components: systematic risk and unique risk = Market risk + company specific risk. the variance explained by the index is systematic risk or market risk. The unexplained variance is called the residual variance, or unsystematic risk or company specific risk.
The

The

coefficient of determination (r2) tells us the percentage of the variance of the security's return that is explained by the variation of return on the index (or market).

Sharpe

suggests that systematic risk for an individual security can be seen as:

 Systematic

risk = X (Variance of index) =

2 I 2

Unsystematic

risk = (Total variance of security (Systematic risk) = e2

return)

Total

Risk

+ e2

Rp =

i=1

Xi (

iI

2 p

N i=1

Xi

N 2 I

i=1

Xi2 ei2

2= variance of portfolio return p 2 = expected variance of index I ei2= variation in security's return not

caused

by its relationship to the index

NUMBER OF SECURITIES

MARKOWITZ COVARIANCES 45 1,225 4,950 499,500 1,999,000

SHARPE INDEX COEFFICIENTS 10 50 100 1,000 2,000

10 50 100 1,000 2,000

Ranking of Securities a single number measures the desirability of including a stock in the optimal portfolio the desirability of any stock is directly related to its excess returnto-beta ratio:

Ri - RF
i

 If

stocks are ranked by excess return to beta (from highest to lowest), the ranking represents the desirability of any stock's inclusion in a portfolio. The number of stocks selected depends on a unique cutoff rate such that all stocks with higher ERBR will be included and all stocks with lower ratios excluded.

 To

determine which stocks are included in the optimum portfolio, the following steps are necessary: 1. Calculate the excess return-to-beta ratio for each stock under review and the rank from highest to lowest. 2. The optimum portfolio consists of investing in all stocks for which ERBRis greater than a particular cutoff point C*.

i 2 m i=1

(Ri RF)
ei i i=1 2 2 i ei 2

Ci = 1+
2 m

Once we know which securities are to be included in the optimum portfolio, we must calculate the percent invested in each security. The percentage invested in each security is:

Xi0 =

Zi
N j=1

Zj

Zi =

i ei 2

(Ri RF)
i

- C*

Consideration of New Securities If the ERBR of the new security is higher than C* , it can enter the optimum portfolio and if the ERBR of the new security is lower than C* , it cannot enter the optimum portfolio. The existence of a cutoff rate is extremely useful for evaluating most new securities candidates to be included in the optimal portfolio.

 Sharpe

notes that proper diversification and the holding of a sufficient number of securities can reduce the unsystematic component of portfolio risk to zero is left is systematic risk which, cannot be eliminated through portfolio balancing.

What

The

Sharpe model attaches considerable significance to systematic risk and its most important measure, the beta coefficient ( )

 According

to the model, the risk contribution to a portfolio of an individual stock can be measured by the stock's beta coefficient. The market index will have a beta coefficient of + 1.0. A stock with a beta of, for example, + 2.0 indicates that it contributes far more risk to a portfolio than a stock with, say, a beta of + .05. Stocks with negative betas are to be coveted because they help reduce risk beyond the unsystematic level.

Because

efficient portfolios eliminate unsystematic risk, the riskiness of such portfolio is determined exclusively by market movements. Risk in an efficient portfolio is measured by the portfolio beta. The beta for the portfolio is simply the weighted average of the betas of the component securities.

 If

the portfolio is properly diversified (proper number of stocks, and elimination of unsystematic risk), it should move up or down in proportion of its positive beta more than the market. A high beta suggests an aggressive portfolio. If the market moves up over the holding period, our portfolio will be expected to advance substantially. However, a market decline should find this portfolio falling considerably in value