THE SHARPE INDEX MODEL Most of the stock prices move with the Market Index.

Some underlying factors affect the market index as well as the stock prices. Ri =i+iRm+ei Where Ri=expected return on security i i=intercept of the straight line or alpha coefficient i=slope of the straight line or beta coefficient Rm=the rate of return on market index ei=error term The return on stocks can be divided into two components, the return due to the market and the return independent of the market.i indicates the sensitive ness of the stock return to the changes in market return. For example i of 1.5 means that the stock return is expected to increase by 1.5% when the market index increases by 1% and vice-versa. Likewise i of 0.5 expresses that the individual stock return would change by 0.5% when there is a change of 1% in the market return.iof 1 indicates that the market return and security returns are moving in tandem. The estimates of i and i are obtained from regression analysis. The variance of Securities return 2=i 2 m+2 ei The covariance between securities i and j is=ij2 m The variance of the security has two components namely, systematic risk or market risk and unsystematic risk or unique risk. The variance explained by the index is referred to as systematic risk. The unexplained variance is called residual variance or unsystematic risk. Systematic Risk=2 I 2 mi Unsystematic risk=total variance-systematic risk e2 i =2 i systematic risk PORTFOLIO VARIANCE2 p=[(i=1 Nxi i )2 2 m ]+[N i=1x2 I e2 I ]

2 p =variance of portfolio 2 m =expected variance of index e2 I =variance in securitys return not related to market index xi=the portion of stock in the portfolio Likewise expected return on the portfolio also can be estimated. For each security i andi should be estimated Rp =N i=1 xi (i +i Rm) Portfolios 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. A portfolios alpha value is a weighted average of the alpha values for its components using the proportion of investment in a security as weight. p=N i=1xi i p =value of the alpha of the portfolio xi=proportion of the investment in security i i=value of alpha for security i N=number of securities in the portfolio Similarly, a portfolios beta values is the weighted average of the beta values of its component stocks using relative share of them in the portfolio as weights. p =N i=1 xi i p =portfolio beta EXAMPLE The following details are given for X and Y companies stock and the Sensex for a period of one year. Calculate the systematic and unsystematic risk for

the companies stocks. If equal amount of money is allocated for the stocks what would be the portfolios risk? X Y SENSEX stock stock Average return 0.15 0.25 0.06 Variance of the return 6.30 5.86 2.25 0.71 0.27 Correlation coefficient 0.424 2 Coefficient of determination( ) 0.18 The coefficient of determination gives the percentage of the variation in the securities return that is explained by the variation in the market index return In the X company stock return 18% variation is explained by variation of the index and 82% is not explained by the index. Explained by the index=variance of security return Coefficient of determination=6.3X0.18=1.134 Not explained by the index=6.3(1-0.18) =5.166 The variance explained by the index is the systematic risk. The unexplained variance or the residual variance is the unsystematic risk. COMPANY X Systematic Risk=2Xvariance of the market index=(0.71)2X2.25=1.134 Unsystematic risk=total variance of security return-systematic risk=e2 I =6.3-1.134=5.166 Total risk=1.134+5.166=6.3 COMPANY Y Systematic risk=(0.27)2 X2.25=0.1640 Unsystematic risk=5.86-0.1640=5.696 2 p=[(2 i= 1 xi i )22 m ]+[2 i= 1 x2 I e2 i] =[(0.5X0.71+0.5X0.27)2 2.25]+[(0.5)2 (5.166)+(0.5)2 (5.696)] = 3.256