Chapter 18: The Sharpe Index Model

Q. 6. The following table provides the α and β values for the stocks for the period
January 1998 – November 1998.

Stock α β
TISCO – 2.06 0.71
Tata Tea – 1.5 0.92
Bajaj Auto 1.15 0.58
ITC Hotels 1.45 1.15

If the market return in 1999 is assumed to be 15 per cent, what will be the portfolio
return for an investor who invests amount of money in the above mentioned stocks?
N
Solution: Portfolio Return = RP = ∑ X1 (α1 + β1 Rm )
i =1

X1 = 1/4
 α1 + βRm
TISCO = – 2.06 + (0.71 × 15) = 8.59
Tata Tea = – 1.5 + (0.92 × 15) = 12.3
Bajaj Auto = 1.15 + (0.58 × 15) = 9.85
ITC = 1.45 + (1.15 × 15) = 18.7
N
RP = ∑ xi (α1 + βRm)
i =1

= – (.25 × 8.59) + (.25 × 12.3) + (.25 × 9.85) + (.25 + 18.7)

= 12.36
Q. 7. The mean returns for the stocks during the year 1998 are given below. The
variances of the returns are also given below.

Stocks Mean Return Variances

Anil Electricals 20% 8
Soruba Ltd 25% 18
Karthik Ltd 35% 22
Arul Ltd 32% 21

The Treasury bill rate is 7 per cent.

1
 Which security is a best buy?
Solution: Rf = 7 %
(Σ ( R ) − R f )
The Return to Risk ratio =
σ
20 – 7
Anil Electricals = = 4.597
2.828
25 – 7
Soruba Ltd. = = 4.242
4.243
35 – 7
Karthik Ltd. = = 5.97
4.69
32 – 7
Arul Ltd. = = 5.455
4.583
The Karthik Ltd yield the highest return.
Q. 8. An investor wants to analyse his portfolio using Markowitz or Sharpe techniques.
His portfolio consists of 25 different stocks. He is not aware of the bits of
information needed to evaluate the portfolio. He wants to adopt a technique which
requires minimum information. As a portfolio manager which method would you
advise him to use? Reason out your answer.

Solution: Markowitz Model

N ( N + 3) 25 (25 + 3)
= = = 350
2 2
= 350 bits of information
Sharpe Model = 3N + 2
= 3 × 25 + 2
= 77 bits of information required.
The investor is advised to use Sharpe model, it requires less information.
Q. 9. Mr. John is a risk cautious person. He is advised by a friend to buy the following
stocks in equal proportion and bits of information regarding the stocks are given
below:

Company β Residual Variance

A 0.84 5
B 1.27 12
C 1.17 18

The market return variance is 25. What is the portfolio risk?

2
 N 2  
N
2 2
Solution: σp2 =  ∑ ( x1 β1) 2 σm   ∑ x1 e1 
+
 i =1   i =1 
2 2
N   1  1 1 
Step 1:  ∑ x1 β1  =   ⋅ 84 +   1.27 +   1.17 
 i =1   3  3 3 
 
= (0.28 + 0.423 + 0.39)2
= (1.093)2
= 1.195
N
∑ ( x1 β1)2σm 2 = 1.195 × 25
i =1

= 29.88
N 2 2 2
1 1 1
∑ x12 e12 =   × 5 +   × 12 +   × 18
 3  3  3
i =1

= .555 + 1.333 + 2
= 3.889
σp2 = 29.88 + 3.889
σp2 = 33.769
σp2 = 33.769
σp = 5.81

Q. 10. The following table gives the data for some stocks. Which stock has the highest
unique risk?

Security Variance R
1 6.30 0.42
2 9.00 0.2
3 8.64 0.18
4 9.12 0.21
5 5.86 0.19
Market 2.69
Solution: σm = 2.69
Unique Risk = Variance of the security return × (1 – r2).
(1) 6.30 × (1 – .422) = 5.189
(2) 9 × (1 – .22) = 8.64

3
 (3) 8.64 × (1 – .182) = 8.360

(4) 9.12 × (1 – .212) = 8.718 ------- Highest Risk

2
(5) 5.86 × (1 – .19 ) = 5.648

Q. 11. A portfolio manager has got the following information about several stocks. He has
to build a optimum portfolio for his client without short sales.

Security Expected Return β α2ei

A 22 1.0 35
B 20 2.5 30
C 14 1.5 25
D 18 1.0 80
E 16 0.8 20
F 12 1.2 10
G 19 1.6 25
H 17 2.0 30

The market index variance is 12 per cent and the risk free rate of return is 7 per cent.
Solution: αm2 = 12, Rf = 7
N ( R1 − R f )
σm 2 ∑ ×β1
i =1 σei 2
Ci = N
βi 2
1 + σm 2
∑ σei 2
i =1

Security Ri β1 R1 – Rf Ri − R f αe2
Bi
A 22 1.0 15 15 35
B 20 2.5 13 5.20 30
C 14 1.5 7 4.67 25
D 18 1.0 11 11.00 80
E 16 0.8 9 11.25 20
F 12 1.2 5 4.17 10
G 19 1.6 12 7.50 25
H 17 2.0 10 5.00 30

4
 βi
Securit Ri − R f ( Ri − R f ) β1 N
( β1 )2 ∑
N
βi 2
y
βi σei 2 2
( Ri − R f ) βi ∑ σei 2
2
σei
σei i =1 i =1
2
σei

A 15 0.43 0.03 0.43 0.03 0.03

E 11.25 0.36 0.032 0.79 0.062 0.04
D 11 0.14 0.013 0.93 0.075 0.013

G 7.5 0.77 0.102 1.7 0.177 0.064

B 5.2 1.08 0.208 2.78 0.385 0.083

H 5 0.67 0.133 3.45 0.518

C 4.67 0.43 0.09 3.87 0.608
F 4.17 0.6 0.144 4.47 0.752

12 × .43
C1 = = 3.79
1 + (12 × .03)
12 × .79
C2 = = 5.44
1 + (12 × .062)
12 × .93
C3 = = 5.87
1 + (12 × .075)
12 × 1.7
C4 = = 6.53
1 + (12 × .177)
12 × 2.78
C5 = = 5.94
1 + (12 × .385)
The portfolio manager selects the first four stocks that is A, E, D and G, because the ‘C’
value declines after ‘G’ stock. The proportions to be invested are given below.
βi  Ri − R f 
Zi =  − C 
σei 2  βi 
ZA = .03 (15 – 6.53) = 0.25
ZE = .04 (11.25 – 6.53) = 0.19
ZD = .013 (11 – 6.53) = 0.06
ZG = .064 (7.5 – 6.53) = 0.06

5
 Zi
XA = N
∑ Zi
i =1

0.25
XE = = 0.446
0.56
= 0.44 6 ×100 = 44.6%
0.19
XD = = 0.34
0.56
= 0.34 × 100 = 34%
0.06
XG = = 0.107
0.56
= 0.107× 100 =10.7 %
0.06
X4 = = 0.107
0.56
= 0.107× 100 =10.7 %
13. An investor wants to build a portfolio with the X, Y and Z stocks. The stocks α and
β are given below. The market is assumed to be bullish and the return from the
market is expected to be 22 per cent.
(a) If he allocates equal proportion to the three stocks, what would be his return?
(b) If he utilises 50 per cent of his money for the purchase of Y stock and divides
the remaining equally between the X and Z stocks, what would be his portfolio
return?

Company α β
X 0.67 0.92
Y 0.89 1.12
Z 0.56 1.88

Solution:
1
(a) Rm = 22, X1 =
3
N
RP = ∑ X1 (α1 + β Rm )
i =1

6
 1
X= (.67 + .92 × 22) = 6.97
3
1
Y= (.89 + (1.12 × 22) = 8.51
3
1
Z= (.59 + 0.88 × 22) = 6.65
3
RP = 6.97 + 8.51 + 6.65 = 22.13

(b) X = .25 (.67 + (.92 × 22) = 5.23

Y = .50 (.89 + 1.12 × 22) = 12.77
Z = .25 (.56 + .88 × 22) = 4.98
RP = 5.23 + 12.77 + 4.98 = 22.98

Q. 15. Arul got the following information regarding his favourite stocks. He wants to
invest in all the four stocks equally.

Stock α β σ2ei
1 1.27 1.50 50
2 1.02 1.05 40
3 2.48 1.37 20
4 0.47 0.86 35

The market variance is 25. The market’s expected return is 20 per cent.
(a) What would be Arul’s portfolio return and risk?
(b) Can you advise him regarding the amount to be allocated on each security so as to
enhance his earnings?

Solution: Rm = 20, α2m = 25

N
RP = ∑ X1 (α1 = β Rm )
i =1

1
R1 = (1.27 + 1.50 × 20) = 7.82
4
1
R2 = (1.02 + 1.05 × 20) = 5.51
4
1
R3 = (2.48 + 1.37 × 20) = 7.47
4

7
 1
R4 = (0.47 + 0.86 × 20) = 4.42
4
RP = 7.82 + 5.51 + 7.47 + 4.42 = 25.22
N  N 
σP2 =  ∑ ( X1 βi ) σm 2  + ∑ X12 e12 
 i =1   i =1 
N
∑ ( X1 β1 ) 2 σm 2 = [(.25 × 1.50) + (.25 × 1.05) + (.25 × 1.37) + (.25 × 0.86)]2 × 25
i =1

= 35.7
N
∑ X12 e12 = (.252 × 50) + (.252 × 40) + (.252 × 20) + (.252 × 35) = 9.06
i =1

σp2 = 35.7 + 9.06

σp2 = 44.76
σp = 44.76
= 6.69