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3 Sharpe Index Model

The Sharpe Index Model provides a simpler approach to portfolio optimization compared to the Markowitz model. It assumes the return of individual securities is linearly related to a single market index. This requires estimating fewer parameters. Specifically, the single index model relates a security's return to the market return using an intercept term, a slope term (beta), and error term. Portfolio risk, return, alpha, and beta can all be estimated as weighted averages of the component securities based on their proportions in the portfolio. Stocks are selected for the optimal portfolio by ranking their excess return-beta ratios and selecting stocks cumulatively until the portfolio's Sharpe ratio is maximized.

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1K views10 pages

3 Sharpe Index Model

The Sharpe Index Model provides a simpler approach to portfolio optimization compared to the Markowitz model. It assumes the return of individual securities is linearly related to a single market index. This requires estimating fewer parameters. Specifically, the single index model relates a security's return to the market return using an intercept term, a slope term (beta), and error term. Portfolio risk, return, alpha, and beta can all be estimated as weighted averages of the component securities based on their proportions in the portfolio. Stocks are selected for the optimal portfolio by ranking their excess return-beta ratios and selecting stocks cumulatively until the portfolio's Sharpe ratio is maximized.

Uploaded by

Ajith
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 18

The Sharpe Index Model


Need for Sharpe Model
 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., (N2 – 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.
Single Index Model
Stock prices are related to the market index and this
relationship could be used to estimate the return of
stock.
Ri = ai + bi Rm + ei
where Ri — expected return on security i
ai — intercept of the straight line or alpha co-efficient
bi — slope of straight line or beta co-efficient
Rm — the rate of return on market index
ei — error term
Risk
 Systematic risk = bi2 × variance of market index
= bi2 sm2
 Unsystematic risk = Total variance – Systematic risk
ei2 = si2 – Systematic risk
 Thus the total risk = Systematic risk + Unsystematic risk
= bi2 sm2 + ei2
Portfolio Variance
 The portfolio variance can be derived
  N

2
  N
2 2
σ p =   x i β i  s m  +   x i e i 
2 2

 i =1    i =1 
where
s p 2 = variance of portfolio
s m 2 = expected variance of index
s i 2 = variation in security’s return not related to the market index
xi = the portion of stock i in the portfolio
Expected Return of Portfolio
 For each security ai and bi should be estimated
N
R p =  x i (αi + βi R m )
i =1
Strongly efficient market
All information is
reflected on prices.
Semi strong efficient market
All public information is
reflected on security prices
Weakly efficient market
All historical information
is reflected on security

 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.
Portfolio Alpha
A portfolio’s alpha value is the weighted average of
the alpha values of its component securities using the
portfolio of the investment in a security as weights.
N
a p   xia i
i 1
Portfolio Beta
A portfolio’s beta value is the weighted average of
the beta values of its component stocks using relative
share of them in the portfolio as weights.

N
b p =  x ib i
i =1

bp is the portfolio beta.


Selection of Stocks
 The selection of any stock is directly related to its
excess return-beta ratio.
Ri  Rf
βi
where Ri = the expected return on stock i
Rf = the return on a riskless asset
bi = the expected change in the rate of return
on stock i associated with one unit change
in the market return
Optimal Portfolio
 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 Ci for all the stocks according to the ranked order
using the following formula
(R i  R f )βi
N
σ 2
m
i =1 σ ei2
Ci
N β2
1 + σ 2m  2i
i =1 σ ei
sm2 = variance of the market index
sei2 = variance of a stock’s movement that is not associated with the
movement of market index i.e., stock’s unsystematic risk
 The cumulated values of Ci start declining after a particular
Ci and that point is taken as the cut-off point and that stock
ratio is the cut-off ratio C.

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