CH APTER 18

THE SHARPE INDEX MODEL

T
he investor always likes to purchase a combination of stocks that pro~ides the highest return and has
lowest risk. He wants to maintain a satisfactory reward to risk ratio. Traditionally analysts paid more
attention to the return aspect of the stocks. Now a days risk has received increased attention and
analysts are providing estimates of risk as well as return.
The Markowitz model is adequate and conceptually sound in analysing the risk and return of the portfolio .
The problem with Markowitz model is that a number of co-variances have to be estimated . If a financial
2
institution buys 150 stocks, it has to estimate 11,175 i.(?. (N -N)/2 correlation co-efficients. Sharpe has devel-
oped a simplified model to analyse the portfolio. He assumed that the return of a security is linearly related to
a single index like the market index. Stricktly speaking, th~ market index should consist of all the securities
trading on the exchange~ In the absence of it, a popular index can be treated as a surrogate for the market index.
For example, even though BSE-Sensex, BSE-100, and NSE- \50 do .not use all the scrips' prices to construct
their indices, they can be used as surrogates. This would dispense the need for calculating hundreds of co-
variances. Any movement in security prices could be understood with the help of index movement. Further, it
needs 3N + 2 bits of information compared to (N [N + 3] / 2) bits of information needed in the Markowitz
analysis.

SINGLE INDEX MODEL

Casual observation of the stock prices over a period of time reveals that most of the stock prices move with the
market index. When the Sensex increases, stock prices also tend to increase and vice-versa. This indicates that
some underlying factors affect the market index as well as. the stock prices. Stock prices are related to the
market index and this relationship could be used to estimate the return on stock. Towards this purpose, the
following equation can be used
R = a+~R , +e
· i m i
where R - expected return on security i
a - intercept of the straight line or alpha co-efficient
~. slope of straight line or beta co-efficient
R - the rate of return on market index
e error term
 f3561 Security Analysis and Portfolio Managemenl
According to the equation, the return of a stock can be divided into !\ID components, the return due to
market and the return independent of the market. p indicates the sensitiveness of the stock return t lhlhe
"the ~rker return. For example P,of 1.5 means
c hanges m ..!...L Oc
that the stock return is expected to increase by 1.S%
when the market mdex return increases by 1 % and vice-versa. Likewise, P, of0.5 expresses that the individual
stock return \IDUld change by 0.5 per cent when there is a change of I per cent in the market return. ~-of 1
indicates that the market return and the security return are moving in tandem. Tue estimates of P and~ are
obtained from regression analysis. ' '
The single index model is based on the ~sumption that stocks Vll!YJoeeibcr hecause of the common ~ -
ment in the stock market and there are no effects be nd e market (i.e. any fundamental factor effects) that
account the stocks co-movement. !he expected return. standard deviation and co-variance of the single index
model represent the joint movement of securities. The mean return.is

i, .R
IThe
_: I
=a
I
+/38 ., _ _ 2 13 21 2 2
variance of security"s return. CJ = 1_ u .. + CJ,;
The covariance of rerums between securities i andj is

CJ=J3J3c/
u .,. i m .
• !\ID com
.
nents namely, systematic risk or market risk and unsyste~nc
The vanance of the secun~ has . l . rby the index is referred to systematic ·risk. Tue unexplamed
risk or unique risk. The vanance exp ame . . .
variance is called residual variance or unsystemanc nsk.
• · k - a 2 x variance of market index.
Systematic ns - 1-'1
=/32CJ2
1 '" • _ S tematic risk.
Unsystematic risk = Total vanance ys
e 2 == CJ 2 - systematic risk.
' ' . . k + unsystematic risk.
Tons, the total risk == Systematic ns
2 2 2
==f3 CJ +e_ .
From this, the portfol;o ~ianc~ can be derived ] [ N 2 2]
N fl )2 2 + 1: x; e;
<7 2 = ( 1: xw; <7m ·:1
p [ i:1 I

a2 == variance of_portfolio

erl -- expected variance of index .

th market mdex
m • ·ry's return not related to e
e 2 == variation 1J1 secun
, • · th •portfolio . d should t,e
x == the partion of stock z m e . ted For each secuntr a, an ,
rtfolio also can be estIJIIJl .
Likewise expected return on the po
 The Sharpe Index Model {357]

~rtfolio return ~s the ~ghted average of the estimated return . . .

...• ,ohts are the respective stQCks' proppoorurtioonnss
thi
th . for each secumy m the portfolio. The
~ e portfoho.
in•

\)'.l<'b"'

A portfolio's_y.lpha value is a w~hted average of th - 1- .

nnrtion of the investment in a security . h e a pha values for its component securities using the
y:::-
Pro as we1g..!.:_ --

N
ap='i:.x-a -
i=l I I

a - Value of the alpha for the portfolio

p

xi - Proportion of the investment on security i

a - Value of alpha for security i ·
I

N - The number of securitie$ in the portfolio

S~arly, a portfoli~'s beta value is the weighted average of the beta values of its component stocks using
relanve share of them m the portfolio as weights.

N
/3 p = i=I
L XI·/3 I
is the portfolio beta.
p

Example: 18.1
The following details are given for X and Y companies' stocks and the B~mbay sensex for a period of one year.
Calculate the systematic and unsystematic risk for the companies' stocks. If equal amount of money is allo-
cated for the stocks what would be the portfolio risk?
XStock YStock Sensex

0.15 0.25 0.06

Average return
6.30 5.86 2.25
Variance of return
0.71 0.27
Correlation Co-efficient 0.424

Co-efficient of determination (/) 0.18

The co-efficient of determination (r2) gives the percentage of the variation in the security's return that is
explained by the variation of the market index return. In the X company stock return, 18 per cent of variation
is explained by the variation of the index and 82 per cent is not explained by the index.
Explained by the index = variance of security return x co-efficient of determination 5c. :,~\,v,:;.,- , c.
=6.3x0.18=1.134 ?>;~ k_
Not explained by the index= Variance of security return X (1-r)
t , I•, J , \
__, "~ - ~, ,
',.JI l, +• (
I'' '>-'1{.
= 6.3 X (1-0.18)
= 6.3 X 0.82 = 5.166
 [358] Security Analysis and Prmfolio Managemenl

According to Sharpe, the variance explained by the index is the systematic risk. The unexplained variance or
the residual variance is the unsystematic risk.

CompanyX:
I
2
Systematic risk = 8 x Variance of market index
2
= (0.71) x2.25
= 1.134
Unsystematic risk = Total variance of security return - systematic risk
2
=e
• I
= 6.3 - 1.134
= 5.166
2 2 2
Totalrisk =B xcr +e
= 1.134 + 5.166
= 6.3
CompanyY:
2 2
Systematic risk = B x CJ
_ i m
2
= (0.27) x2.25
=0.1640
Unsystematic risk= Total variance of the security return - systematic risk.
= 5.86-0.1640
= 5.696

2 [('f.x;{J;)
O"p= N 2am+
2] [_'Nf-x;e;
22]
i=I 1=1
2 2 2
= [(.5 X .71 + .5 X .27) 2.25] + [(.5) (5.166)+(.5) (5.696)]
= [(.355 + .135)2 2.25] + [(1.292 + I°.424)]
= 0.540 + 2.716
= 3.256
CORNER PORTFOLIO
The entry or exit of a new stock in the portfolio generates a series of comer portfolio. In an one stock portfolio,
it itself is the comer portfolio. In a two stock portfolio, the minimum attainable risk (variance) and the lowe 5t
 The Sharpe Index Model [359]

return would be the. comer portfolio · As the number of stocks mcreases

• . a portfolio· the comer portfolio
m
would be the one with lowest return and risk combination. '

Corner Portfolio

R ------------------ B

Q , ' - - - - - - - - - - - 1 - - - - - ap
Fig.18.1.
In the above diagram, AB line shows the risk-return combinations of several portfolios. Each number
indicates the number of stocks in the portfolio. When the number of stock increases, the risk and return decline .
Tracing down the AB line shows the corner portfolio. An efficient frontier may have one or two security
portfolio at the low or high extremes, if the percentages of allocation to stocks are free to take any value.

SHARPE'S OPTIMAL PORTFOLIO

Sharpe had provided a model for the wection of ap.pmpriate securities io a partfolio The selection of any stock
is directly related to its excess return-beta ratio.

Where,
R = the expected return on stock i
i
R = the return on a riskless asset
B = the expected change in the rate of return on stock i associated with one unit change in the market
f

i
return
d the riskless rate
The excess return is the difference between the ex ec
such as the rate offered on the government 'security or treasury bill. The excess return to beta ratio measures
, the additional return on a security (excess of the riskless asset return) per unit of systematic risk or non-
diversifiable risk. This ratio provides a relationship between potential ri'sk and reward.
Ranking of the stocks are done on the basis of their excess return to beta. Portfolio managers would like to
include stocks with higher ratios. The selection of the stocks depends on a unique cut-off rate such that all
stocks with higher ratios of Ri-R/ B, are included and the stocks with lower ratios are left off. The cut-off point
is denoted by C*.
 {360] Security Analysis and Prmfolio Managemelll

The steps fot finding out the stocks to be included in the optimal portfolio are given below

I. Find out the "excess return to beta" ratio for each stock under consideration.

2. Rank them from the highest to the lowest.

3. Proceed to calculate C_for all the stocks according to the ranked order using the following formula.

I 2 N(R;-RJ)/3;
am _:E 2
z=I O'ei
C;----N-'"----R2-
I + a 2 :E _,.,_,;
m i=Ja2·
2
= variance of the market index
el
er
m

er
2
= variance of a stock's movement that is not associated with the movement of market index i.e. stock's
ur/systematic risk.

4. The cumulated values of C start declining after a particular C and that point is taken as the cut-off point
1
and that stock ratio is the dut-off ratio C.

This is explained with the help of an example.

Data for finding oiit the optimal portfolio are given below

Security Mean Excess Beta Unsystematic Excess Return

Number Return Return Risk to Beta
R;-RJ
R
;
R-R, /J u2
d B,

,,,.,...
2
1 19 14 1.0 w 14
'-
.----
23 18 1.5 30 12 /
---
<_:..
3 11 6 0.5 10 12 /
4 25 w 2.0 40 IO / ----
.,-

5 13 8 1.0 w 8 ,.,.- rv

6 9 4 ,.-- ~.
7 14 9
0.5

1.5
50
30
8
--·J
6
------
The riskless rate of interest is 5 per cent and the market variance is 10. Determine the cut-off point.

\ 'l- ( R,·- f<t 1

C; =- ovV\
 The Sharpe Index Model {361]

Security (R, -R1)P1 N p2

i=l a,;, I:-'
i=la,;;
Numberl 3 4 5 6 7
1 14 0.7,,.-' 0.7 / 0.05/ 0.05 / 4.67 .,
2 12 0.9 ,,,.- 1.6 / O.Q7Y 0.125 / 7.11 r
3 12 0.3
4
1.9 / 0,025 ,.,.., 0.11/"' Jfii.. ., :,k
10
o.25 r ~ .::...
1,Q / 2.9 /'

-
5 /
0.1 ,.. C
8 0.4 /
3.3 /' 0.05 ' 0.3 / 8 25 /
Q 8 0.04 3.34 0.005 l' v 0.305 /' 8:25 /
7 6 0.45 __,,,,.-· 3.79 I' O.Q75 , i.,, 0.38 / 7.00 .,,,.-

c.calculations are given below

I

For Security 1

C1
lOx .7
= 1+ (10 X .05) = 4.67 I 4- (roM (J i. )
Here OJ is got from column 4 and 0.05 from column 6. Since the preliminary calculations are over i~/s
easy to calculate the C . '
i

lO x l.6
C2=----=7.11
1 + (10 x .125)
C3 = lOxl.9 7.6
I +10(0.15)
_ 10x2.9
C4 - - - - - 8.29 -
1 +10(0.25)
Cs = 10 x 3.3 = 8.25
1 + 10(0.3)
C6 = 10 X 3.34 = 8.25
1 + 10(0.305)
C7= 10 x 3.79 =7 .90
1 + 10(0.38)
The highest C. value is taken as the cut-off point i.e. C* . The stocks ranked above C* have high excess
returns to beta th~ the cut-off C and all the stocks ranked below C*have low excess returns to beta. Here, the
cut-off rate i~Hence, the first four securities are selected. If the number of stocks is larger there is no
need to calculate C values for all the stocks after the ranking has been done. It can be calculated until the C*
value is found and ~fter calculating for one or two stocks below it, the calculations can be terminated.
The C. can be stated with mathematically equivalent way.
'
 [361] Security A.110/ysis and Portfolio Ma11agemen1

/31p(Rp -R1)
c, = _,__,.___.,__
/3;
13;• - the expected change in the rate of return on stock i associated with I per cent change in the return on
the optimal portfolio.
R• - the expected return on the optimal portfolio
13;• and R,• cannot be determined until the optimal portfolio is found. To find out the optimal portfolio, the
formula given previously should be used. Securities are added to the portfolio as long as
R;-RJ
--->C;
/3;
The above equation can be rearranged with the substitution of equation :

Now we have,
R - R > (R-R)
i r ip p r
The right hand side is the expected excess return on a particular stock based on the expected performance
of the optimum portfolio. The term on the left hand side is the expected excess return on the individual stock.
Thus, if the portfolio manager believes that a particular stock will perform better than the expected return
based on its relationship to optimal portfolio, he would add the stock to the portfolio.

CONSTRUCTION OF THE OPTIMAL PORTFOLIO

After determining the securities to be selected, the portfolio manager should find out how much should be
invested in each security. The percentage of funds to be invested in each security can be estimated as follows

X=_!J_
I N
r, z,
i=I

Z_-/J;
- ---C
I 2
[R; -RI •]
O",; /J;
The first expression indicates the weights on each security and they sum upto one. The second shows the
relative investment in each security. The residual variance or the unsystematic risk has a role in determining
the amount to be invested in each security.

Taking up the previous example

I
Z1 = -(I 4 - 8.29) = 0.28~
20
Z2 =1.5
- (12-8.29) =0.186
30
 111111

The Sharpe Index Model {363]

0 .5
Z 3 = -(12 - 8 .29) = 0 . 186
10
2
Z4 = -(10 - 8 .29) = 0 .086
40
N
;:, = 0 .285 + 0.186 + 0.186 + 0 .086

= .743
/

X1 = 0.285 = 0.38
0.743
X2 = 0.186 = 0.25
0.743
X3 = 0 . 186 = 0 .25
0 .743
X4 = .0.086 = 0.12
0.743
Thus, the proportions to be invested in different securities are obtained. The largest investment sliould be
made in security I and the smallest in security 4.

OPTIMUM PORTFOLIO WITH SHORT SALES

The procedure used to calculate the optimal portfolio when short sales are allowed is, more or less similar to
the procedure adopted for no short sales, except the cut-off point concept. At first, the stocks have to be ranked
by excess return to beta. Here, all the stocks are added to the portfolio. They are either held long or short. All
the stocks affect the cut-off point. The Z value has to be calculated for each stock. If the Z value is positive, the
stock will be held long and if negative, it will be sold short. Stocks which are having excess return to beta above
C* are held long as in the case of the portfolio without short sales. Stocks with an excess return to beta below
C* are sold short. In the case of previous example C* = C 7 = 7 . 9, if short sales are permitted, then

Z;=-
2
P; (R;
- --R1
- - C •]
u,; p
1
z, = -(14 - 7 .9) = 0.305
20
Z 2 = _1_2(12 .- 7 .9) = 0.205
30
Z3 = ~(12 - 7 .9) = 0.205
10
2
Z4 = -(10-7.9)=0.105
40
Z5 = __!_(8 - 7 .9) = 0 .005
20
 [364} Security Analysis and Portfolio Manage~nl

z6 = 0·5cs- 1.9) = 0.001

50
Z., =.!.2(6-7.9) =-0.095
30
The seventh stock will be sold short.
The proportion can be had using:
z.
X;=r
E z.
i=I I

SUMMARY
• The Sharpe model is based on the security's return relationship with the index return. Beta is the deciding
factor in measuring the systematic risk. The systematic and unsystematic risk can be computed with the
Sharpe model.
• Using the Sharpe model, portfolio return and risk can be computed easily, compared to the Markowitz
model.

REVIEW PROBLEMS
I. How many inputs are needed for a portfolio analysis involving 4' securities, for Sharpe and Markowitz
models? 50
Solution
Sharpe = (3 N) + 2
=50x3+2
= 152
Markowitz = [N(N+3)]/2
= 1325
2. The following table provides information regarding the portfolio return and risk
Portfolio Expected Return E(R) <J

10 4
2 12 7
3 13 5
I 4 16 12
5 20 14
a) The treasury bill rate is 5 per cent. Which portfolio is the best?
b) Would it be possible to earn 12 per cent return with cr of 4 per cent?
c) If <J is 12 per cent what would be the expected return?
 The Sharpe Inda Model [365]

sorutlon .
• formation given is only the R E(R) and With thi
fhe in . . . . r' cr · 1 s, the return to risk ratios can be found out and the
higbest yielding return to nsk ratio can be selected as the best portfolio .
Portfolio {E(R)-RJ Io
. j
l (10-5)/4 = 1.25
2 (12-5)/7 = 1.0
3 (13 - 5) / 5 = 1.6
4 (16-5)/12=0.92
5 (20-5)/ 14 = 1.07
a) The third portfolio yields the highest return for a unit of risk.
b) If cr = 4, then the best portfolio will yield:
= 5 + 4 (l.6)
E(R) = 11.4
It may not be possible to get 12 per cent return.

c) = 12
If cr

E(R) = 5 + 12 (1.6)

= 24.2
3) An investor wants to build a portfolio with the following four stocks. With the given details, find out his
portfolio return and portfolio variance. The investment is spread equally over the stocks.

Company a /J Residual Variance

Sneha 0.17 0.93 45.15

Neha 2.48 1.37 132.25

Asha 1.47 1.73 196.28

Priya 2 .52 1.17 51.98

Market return (R )
m
= 11
Market return variance = 26
Solution
N
Portfolio Return RP= :E X;(a; + /3;Rm)
i=I

RI = 0.17
.
+ 0.93 (11) = 10.4

R = 2.48 + 1.37 (11) = 17.55

2
[366] Security Analysis allii Portfolio Management

R = 1.47 + 1.73 (11) = 20.5

3
R
4
= 2.52 + 1.17 (11) = 15.4
R = 10.4x .25+ 17.55x.25+20.5x.25+ l5.4x.25
= 2.6 + 4.39 + 5.125 ,: 3.85
= 15.965

N 2[
ap = (_LX N
1,81) am+ _
L X1 e; 2 2] [ 2 2]
1=1 1=1
2
cr = Variance of the index
2
e = Residual variance
N 2
( L X ,81) 2 ; (.25x.93 +.25xl.37 + .25xl.73+.25xl.17)
1
i=I
2
= (.2325 + .3425 + .4325 + .2925)

= (Li

= 43 .94
x?el = (.25) 2 (45.15)+(.25)2(132.25)+(.25) 2 {196.29)+{.25) 2 (51.98)
i=I - -

= 2.822 + 8.266 + 12.269 + 3.249

= 26.606
2
cr = 43.94 + 26.606
= 70.546
0 = 8.399
p
-\1 Mr. David is constructing a optimum portfolio. The market return forecast says that it would be 13.5 per
cent for the next two years with the market variance of 10 per cent. The riskless rate of return is 5 ·per cent.
The following \securities are under review. Find out the optimum portfolio.
-._ /
 The Sharpe Inda Model [367}

l
Company a p '1-
(i (j

"
Anil 3.72 0.99 9.35
Avil l3, o.ro 1.27 5.92
Bow C, 0.41 0.96 9.79

Viril l) -0.22 1.21 5.39

Billy b 0.45 0.75 4.52

solution
Expected return for the individual security should be found out

R
i
= a+j3Rm
Anil = 3.72 + .99 (13.5) = 17.09
Avil = o.ro + 1.21 (13.5) = 11.15
Bow = + 0.96 (13.5) = 13 .37
0.41
Viril = - 0.22 + 1.21 (13.5) = 16.12
Billy = 0.45 + 0.75 (13 .5) = 10.58.
R;-Rf (R;-R1 ){3; /if f (.R; - Rt ){3; l /if
Company p a;; -2
O'e; i=l cr;; i=lcr;;
Ci

.105 1.280 ,,- .105 6.244

Anil 12.212 1.280
.272 4.015 .377 8.417
Avil 10.039 2.735
.272 6.511 .649 8.693
Viril 9.190 2.496
.004 7.332 .743 8.6'J7 v
Bow 8.719 0.821
.124 8.258 .867 8.540
Billy 7.440 0.926

Using the formula, the C points are found out and given in the above table

C; = N p2
1+0'2 I . - j
m l=lcr2
el
The proportions of stocks in the optimal portfolio are given below:
Z-
X;=r
I. z,
i=l
[368] Stauity Analysis and Portfolio Managtmmt

z = 0·99 (12.212 - 8.697) = 0.372

I 9.35
2i = 1.27 + 5.92 (10.039- 8.697) = 0.288
Z3 = l.2i + 5.39 (9.190- 8.697) = 0.111
24 = 0.96+9.79 (8.719-8.697) = 0.002
0.773
372
Z-
Xi=,j- = 00.773
· = 0.4812 ~r 48.12%
:E Z;
l=l

= 0 ·288 = 0.372 or 37.26%

0.773

= O.lll = 0.1436 or 14.36%

0.773

= 0.002 = 0.0026 or 00.26%

0.773
5) Vinoth received Rs.10 lakh from his pension fund. He wants to invest in the stock market. The treasury
bill rate is 5 % and the market return variance is 10. The following table gives the details regarding the
expected return, beta and residual variance of the individual security. What is the optimum portfolio
assuming no short sales?
l
Security Expected Return Beta (7
a

A 15 1.0 30
B 12 1.5 '.!)

C 11 2.0 40
D 8 0.8 10
E 9 1.0 '.!)

F 14 1.5 10

Solution
Securities have to be ranked from the highest return to beta to the lowest.

Security R R1 -R1
P, R-R
I I I P,
...
-

A 15 1.0 10 / 10.00 / J,

B 12 1.5 7/ 4.67 /
 The Sharpe Index Model [369]

C 11 2.0 6/ 3.00'
D 8 0.8 3 .......... 3_75,.; :rf-
E 9 1.0 4/ 4.00 /
F 14 1.5 9/ 6.00/ :rr...
Ranked Table

R;-RJ (R; -R1 )xP;

Security Pl ~(R;-R1)P; N p2 C;

1/
2 I-'
O'e;
/" y 2
i=I 2
O'e; i=la2.
,J"' v
A _,.. 10.0 0.333 .033 .333 .033 2.504
6.0 1.350 .225 1.683 .258
B / 4.67 0.525< .113 2.208 .371 4.688
E"' 4.0 0.200 .050 2.408 .421 4.622
D.,,. 3.75 0.240 .064 2.648 .485 4.~26
c . .- 3.0 0.300 .100 2.948 .585 4.304

10 X .333
CA=----
1 + (10 X .03_3)
= 3.33 = 2.504
1.33
_ 10 X 1.638 . he /t'q} '
C F-
l+ (10 x .258)

=- t ; -c)j_
= 16.83 = 4.701
3.58 7,j I

_ 10x2.208
C s-
l+(l0x.371) z_; ----;;--
-f'~
rr _1.
= 22.08 = 4.688 1:::> e,
4.71
The optimal portfolio consists of securities A and F. The p,:o_portions are

V - L;
-"-1-y-
EZ;
i=I
[370] Security Analysis and Portfolio Management

z, =-~
I <1,,
· ll(R;-R,)-c•]
l /3,
Z . = 1 + '30 (10-4 .701)
A

= 0.175
Z = 1.5 + 10 (6- 4.701)
F
= 0.195

X =0.175+0.37
A

= 0.473 = 47.3%

X =0.195+0.37
F

= 0.5270 = 52.70%

The funds to be allocated in securities A and Fare 47.3 and 52.7 per cent.
6. · Taking the previous example, what are the stocks to be held long and short assuming short sales?

Solution
If short sales are permitted. The sum of C. all stocks is taken as the cut of point, hence the c• is 4.304.
I

Z = 1+30(10-4.304)
A
= 0.1899
Z = 1.5 + 10 (6- 4.304)
F .

= 0.2544
Z = l.5+20(4.67-4.304)
B
= 0.02745
Z = l.0+20(4-4.304)
E
= -0.0152
ZDI = 0.8 + 10 (3, 75 - 4.304)
= -0.04432
zc = 2.0+40(3.0-4.304)
= -0.065
A, F and B stocks can be held long while ,E, D and c can be sold short.
 The Sharpe Index Model [371]

7. The following table gives data on four stocks.

Stock Alpha Variance Systematic Unsystematic
A -.06 5 4
B .1 2 6

C .00 3 1
D - .14 3 2
Toe market is expected to have a 12 per cent return over a forward period with a return variance of 6 per
cent. Calculate the expected return for a portfolio consisting of equal portion of stocks A, B, C and D.

Solution
N
Ri = i:?i(ai + Pi Rm)

6 values are not given., They have to be found out.

Systematic risk =6 2
x variance of index
A: 5 =6 2
X 6

~=/32

i
6

=/J=0.91
2
B: 2= 6 X6
.B = .57
C: 3 = .82 X 6
.B = .707
D:\ 3 = .82 X 6
.B = .707
Expected return
R =R +~R
F I m

.A: R = -.06 + (.91 x 12)

= 10.86
B: R = ..1 + (.57 X 12)
=6.94

lll
 [372] Security Analysis and Portfolio Management

C: R = .00 + (.707 x 12) = 8.484

I i
D: R = - .14 + (0.707 x 12) = 8.344

N
RP= L X;(a; + /J; Rm)
. i=l
= .25 X 10.86 + .25 X 6.94 + .25 X 8.484 + .25 X 8.344
= 2. 715 + I. 735 + 2. 121 + 2.086
R = 8.657
Case
The market information regarding the following stocks is given in the table.

a p e'Il-
Stock
-.05 +1.6 .04
ABC
+.08 -0.3 .00
RSE
.00 +1.1 .10
GIV
a) If the market index is expected to have a return of .20 and a variance of .20 which single stock would
' I
the investor prefer to own from the risk and return point of view?

b) Interpret the el value and the avalue of RSE.

Solution
a) Return : R.I = a.I + I
Rm
ABC : R = -.05 + (1.6 x .2) = .27
RSE : R = + .08 - (0.3 x .2) = .02
GIV :_R = .OQ + (1.1 x .2) = .22
Since the return of ABC is higher than other stocks, the ABC stock can be selected.
Risk of the security = Systematic risk + unsystematic risk
Systematic Risk = J32 x variance of index
2 .
= (1.6) X 0.2 = 0.512
= (-0.3)2 x0.2 = 0.018
=(l.1)2 X 0.2 =0.242
Unsystematic risk = e2
Now, the totµ risk
ABC:cr = 0.512 + 0.04 = 0.552
RSE:cr= 0.018 + 0.00 = 0.018
GN:cr =0.242 + 0.10 =0.342