Assignment on SAPM Portfolio

Construction.

Date : 27/1/2020
Name : Pratheeka
Registration
Number : 2SU19MB854
1. EXECUTIVE SUMMARY:
This assignment is based on Sharpe’s single index model formula for finding out optimum
portfolio out of securities. For this top 30 securities are selected from BSE Sensex. Later for
market return I chose S&P BSE dollex 30 index. After applying Sharpe’s model we understand
that out of 30 securities what are those securities to be included in the portfolio to make it an
optimum one. This can be helpful for the investors to decide what are the securities to be
included in his portfolio so that he can get highest return with the expected level of risk he wants
to bear to hold the securities for the specific period. A highly risk averse investor will hold the
securities portfolio on lower left hand segment of the efficient frontier, while an investor who is
not too risk averse will hold the upper part of efficient frontier. So the investor can take the
decision to choose his portfolio to maximize his return from the bunch of securities present in the
portfolio.
2. METHODOLOGY:
a. Objectives-
 The study is conducted to know how to construct an optimum portfolio using wide range
of securities
 To understand the impact of various factors on risk and return of portfolio
 To understand the Practical application of sharpes model in an optimum portfolio
construction
 To understand how to analyse securities using alpha, beta and such other factors.
 To have a brief idea of how to collect the information for the purpose of study from the
internet.
b. About the index-
An index is a method to track the performance of a group of assets in a standardized way.
Indexes typically measure the performance of a basket of securities intended to replicate a certain
area of the market. These could be a broad-based index that captures the entire market, such as
the Standard & Poor's 500 Index or Dow Jones Industrial Average (DJIA), or more specialized
such as indexes that track a particular industry or segment. However to assess how the index has
changed from the previous day, investors must look at the amount the index has fallen, often
expressed as a percentage. For this assignment I have used said index that is S&P BSE dollex 30
index as a index for required calculations.
a. About SENSEX-
Sensex, otherwise known as the S&P BSE Sensex index, is the benchmark index of India's BSE,
formerly known as the Bombay Stock Exchange.) The Sensex is comprised of 30 of the largest
and most actively-traded stocks on the BSE, providing a gauge of India's economy. The index's
composition is reviewed in June and December each year. Created in 1986, the Sensex is the
oldest stock index in India. Analysts and investors use it to observethe cycles of India's economy
and the development and decline of particular industries. The term Sensex was coined by stock
market analyst Deepak Mohoni and is a portmanteau of the words sensitive and Index. The
constituents of the index are selected by the S&P BSE index Committee based on five criteria: it
should be listed in India on BSE, it should be a large-to mega-cap company, the stock should be
relatively liquid, the company should generate revenue from core activities, and it should keep
the sector balanced broadly in line with the Indian equity market. The BSE's index is calculated
using the free-float market capitalization methodology. The level of index at any point of time
reflects the free-float market value of 30 component stocks relative to a base period. The market
capitalization of a company is determined by multiplying the price of its stock by the number of
shares issued by the company. This market capitalization is further multiplied by the free-float
factor to determine the free-float market capitalization. The calculation of the Sensex involves
dividing the free-float market capitalization of 30 companies in the index by a number called the
index divisor. The divisor keeps the index comparable over time and is the adjustment for all
index adjustments. The S&P BSE SENSEX is the benchmark index with wide acceptance among
individual investors, institutional investors, foreign investors and fund managers.
b. Risk free rate of return-
The risk free rate is minimum return an investor is willing to accept at an investment level. In
other words, if the risk of an investment goes up, investors must receive a higher return in order
to entice them to make the investment. Risk-free investments have an actual return that is equal
to the expected return because there is no default risk. Furthermore, a risk-free investment
generates lower returns that any other investment that incorporates a higher risk and should
reward investors with higher returns. The relationship between the interest rate for zero risk
investments and options depends on the correlation between the interest rate and the options.
Most of the time, the calculation of the risk-free rate of return depends on the time period that is
under evaluation. Suppose the time period is for one year or less than one year than one should
go for the most comparable government security, i.e. Treasury Bills.
For example, if the Treasury bill quote is .389, then the risk-free rate is .39%.If the time duration
is in between one year to 10 years, then one should look for Treasury note. For Example: If the
Treasury note quote is .704, then the calculation of the risk-free rate will be 0.7%
Suppose the time period is more than one year than one should go for Treasury bond. For
example, if the current quote is 7.09, then the calculation of the risk-free rate of return would be
7.09%.
For this assignment we have taken 6% as risk free rate as it is the rate prevailing as of 2019-
2020.
c. Time period involved-
Time period is the time line that is taken for calculations. For calculating market return monthly
return is taken from April 2019 to March 2020, later average return is calculated by dividing
total of monthly return with the no. of months, same way for calculating individual return of 30
companies monthly return was taken later average return is obtained for each of 30 securities of
BSE Sensex.

3. THEORETICAL BACKGROUND:
 About Alpha
Alpha (α) is a term used in investing to describe an investment strategy's ability to beat the
market, or its edge. Alpha is thus also often referred to as excess return or abnormal rate of return
which refers to the idea that markets are efficient, and so there is no way to systematically earn
returns that exceed the broad market as a whole. Alpha is often used in conjunction
with beta (the Greek letter β), which measures the broad market's overall volatility or risk,
known as systematic market risk.
Alpha is used in finance as a measure of performance, indicating when a strategy, trader, or
portfolio manager has managed to beat the market return over some period. Alpha, often
considered the active return on an investment, gauges the performance of an investment against
a market index or benchmark that is considered to represent the market’s movement as a whole.
The excess return of an investment relative to the return of a benchmark index is the
investment’s alpha. Alpha may be positive or negative and is the result of active investing.
  About Beta
A beta coefficient can measure the volatility of an individual stock compared to the systematic
risk of the entire market. The beta calculation is used to help investors understand whether a
stock moves in the same direction as the rest of the market. It also provides insights about how
volatile–or how risky–a stock is relative to the rest of the market. For beta to provide any useful
insight, the market that is used as a benchmark should be related to the stock. It is a measure that
indicates the extent by which the stock price moves in relation to general movement in the prices
of stock in the market. If market return is taken as 1 beta can be more or less than 1. If it’s more
the stock is considered to be aggressive. When market is in boom phase return on stock is more
than that of index, if there is a bear phase situation will be reversed. If it is less than 1 then gain
and loss will be less than that of market. If t is equal to 1 then return will be equals to market
return. There are also stocks with negative beta the price of shares of such companies move
opposite to the movement in the index.
 Standard deviation and variance
The standard deviation is a statistic that measures the dispersion of a dataset relative to
its mean and is calculated as the square root of the variance. The standard deviation
is calculated as the square root of variance by determining each data point's deviation relative to
the mean. If the data points are further from the mean, there is a higher deviation within the data
set; thus, the more spread out the data, the higher the standard deviation. A lower standard
deviation isn't necessarily preferable. It all depends on the investments and the investor's
willingness to assume risk. When dealing with the amount of deviation in their portfolios,
investors should consider their tolerance for volatility and their overall investment objectives.
Variance is derived by taking the mean of the data points, subtracting the mean from each data
point individually, squaring each of these results, and then taking another mean of these squares.
Standard deviation is the square root of the variance. The variance helps determine the data's
spread size when compared to the mean value. As the variance gets bigger, more variation in
data values occurs, and there may be a larger gap between one data value and another. If the data
values are all close together, the variance will be smaller. However, this is more difficult to grasp
than the standard deviation because variances represent a squared result that may not be
meaningfully expressed on the same graph as the original dataset.
 Residual variance
This risk effects one industry or a few companies. We can call such risks as company- specific or
industry specific risks. It is also called diversifiable risks. By spreading investment among
industries having opposite risk profiles, the risk can be reduced. By owning a variety of company
stocks across different industries, as well as by owning other types of securities in a variety of
asset classes, such as Treasuries and municipal securities, investors will be less affected by single
events. Even a portfolio of well-diversified assets cannot escape all risk, however. The portfolio
will still be exposed to systematic risk, which refers to the uncertainty that faces the market as a
whole and includes shifts in interest rates, presidential elections, financial crisis, wars, and
natural disasters
 About calculation of return
The expected return of a portfolio is the anticipated amount of returns that a portfolio may
generate.
The return for the securities can be calculated by using formula (closing price- opening
price)/opening price where stock has 2 values at the end of every day in stock market register for
every security that has been traded.
However for this assignment we have taken monthly returns from the data available in BSE
portal for top 30 companies of BSE Sensex from April 2019 to March 2020.These monthly
returns are converted into average return by adding all the returns and dividing it by number of
months i.e. 12.
 About Sharpes method of Portfolio construction
The basic notion underlying the single index model is that all stocks are affected by movements
in the stock market. Casual observation of share prices reveals that when the market moves up
(as measured by any of the widely used stock market indices), prices of most shares tend to
increase. When the market goes down, the prices of most shares tend to decline. This suggests
that one reason why security returns might be correlated and there is co-movement between
securities, is because of a common response to market changes. This co-movement of stocks
with a market index may be studied with the help of a simple linear regression analysis, taking
the returns on an individual security as the dependent variable (RI) and the returns on the market
index (Rm) as the independent variable.
Sharpe had provided a model for the selection of appropriate securities in a portfolio. The
selection of any stock is directly related to its excess return-beta ratio.
(RI – RF)/ Bi
Where,
RI - Return on security.
RF is Risk free rate of return.
Βi is Beta of the security.
The excess return is the difference between the expected return on the stock and the riskless rate
of interest 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 risk 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 excess return to
beta are included and the stocks with lower ratios are left off. The cut-off point is denoted by C*.
The steps for finding out the stocks to be included in the optimal portfolio are given below:
1. 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 formula of
Sharpe’s model for Ci calculation
The highest Ci value is taken as the cut-off point i.e. C*. The stocks ranked above C* have high
excess returns to beta than the cut-off C and all the stocks ranked below C*have low excess
returns to beta.
4. After determining the securities to be included, 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 using formula specified.
Thus, the proportions to be invested in different securities are obtained.

4. ANALYSIS DONE:
Analysis is done to arrive at an optimum portfolio at the end with the some weightage for
selected securities through calculation of alpha, beta, residual variance, market return, market
variance, individual return. Etc.
It includes various tables from 1 to 5 that shows various calculation done to arrive at the final
portfolio construction which are as below-
Table 1 to table 5 are prepared to analyse the collected data to arrive at optimum portfolio with
securities

Months Market
return

April -0.43

May 1.29

June -0.47

July -4.23

August -2.85

September 2.29

October 1.28

November -1.66

December -2.01

January -3.99

February -9.43

March -30.26
Table 1 Showing the monthly market return of S&P BSE
DOllex 30 index from April 2019 to March 2020

Table 2 Showing average return of 30 securities from April 2019 to March 2020.

name Ri
Dr.reddy 0.69
Uniliver 2.48
Bajaj Auto -2.51
Bajaj finance -0.76
Bajaj Fin -1.76
Icici -1.21
Bharthi Airtel 2.33
Maruthi -2.63
SBIN -3.23
Titan -1.05
Kotak bank -0.14
HDFC -1.35
Indus india
Bank -9.46
LT -3.95
Ultra cement -1.59
M&M -6.09
Ntpc -4.06
Tech M -2.3
Reliance -1.83
ONGC -6.81
Asian Paint 0.76
Axis Bank -4.73
Power Grid -1.98
TCS -0.87
Hcl Tech -6.12
Infosys -1.15
HDFC Bank -6.79
ITC -4.6
Nestle Ind 3.27
sun pharma -2.36

name beta Rv alpha

Dr.reddy -0.04 24.43 0.53
Uniliver -0.08 25.91 2.13
Bajaj Auto -1.38 -18.52 -8.32
Bajaj finance 7.86 47.67 1.06
Bajaj Fin 1.85 54.34 6.01
Icici 1.31 8.42 4.28
Bharthi Airtel 0.66 49.19 5.1
Maruthi 1.25 45.76 2.63
SBIN 1.32 55.61 2.32
Titan 0.97 74.86 3.02
Kotak bank 0.83 23.04 3.37
HDFC 0.99 24.95 2.8
Indus india
Bank 2.08 86.06 -0.69
LT 1.21 37.38 1.15
Ultra cement 0.84 39.91 1.93
M&M 1.32 45.16 -0.56
Ntpc 0.97 -7.03 0
Tech M 0.78 38.63 0.99
Reliance 0.67 29.54 1.01
 5.00E+0
ONGC 1 1 -2.48
Asian Paint 0.29 29.75 1.96
Axis Bank 0.56 183.78 -2.35
Power Grid 0.41 13.67 -0.28
TCS 0.35 34.38 0.62
Hcl Tech 0.57 210.88 -3.7
Infosys 0.33 37.89 0.23
HDFC Bank 0.57 173.53 -4.41
ITC 0.47 22.31 -2.63
Nestle Ind 0.08 15.2 3.6
sun pharma 0.16 60.18 -1.7

Table 3 Showing alpha, beta and residual variance for 30 Sensex companies for 12 months from
April 2019 to March 2020

name Ri-Rf/Bi Rf
Dr.reddy 132.75 6
Uniliver 44.00 6
Bajaj Auto 6.17 6
Bajaj finance -0.86 6
Bajaj Fin -4.19 6
Icici -5.50 6
Bharthi Airtel -5.56 6
Maruthi -6.90 6
SBIN -6.99 6
Titan -7.27 6
Kotak bank -7.40 6
HDFC -7.42 6
Indus india
Bank -7.43 6
LT -8.22 6
Ultra cement -9.04 6
M&M -9.16 6
Ntpc -10.37 6
Tech M -10.64 6
Reliance -11.69 6
ONGC -12.81 6
Asian Paint -18.07 6
Axis Bank -19.16 6
Power Grid -19.46 6
 TCS -19.63 6
Hcl Tech -21.26 6
Infosys -21.67 6
HDFC Bank -22.44 6
ITC -22.55 6
Nestle Ind -34.13 6
sun pharma -52.25 6

Table 4 Showing the excess return to beta and corresponding ranking for the same for 30
securities.

sum of
((ri- ri-
rf)bi)/ei2 bi2/ei2 rf*bi/ei2 sum of bi2/ei2 ci value rm2 Zi XI
-
6.549E- 0.6129687 0.205610 0.5214181
0.0087 05 0.0087 6.549E-05 1 70.83 5 4
-
2.470E- 1.3556144 0.113706 0.2883536
0.0109 04 0.0196 3.125E-04 2 70.83 3 4
-
-1.028E- 7.1733574 0.075012 0.1902282
-0.6341 01 -0.6341 -1.025E-01 7 70.83 6 2
-
3.995E- 0.394329
0.1957 02 -0.4384 -6.257E-02 9.0491014 70.83 5 1
3.505E-
0.1971 02 0.1971 -2.752E-02 -14.703557 70.83
2.262E- 6.4799461
1.1817 01 1.3788 1.987E-01 7 70.83
3.872E- 0.4094029
0.1030 02 0.1030 2.374E-01 4 70.83
4.162E- 1.2392063
0.2603 02 0.3632 2.790E-01 6 70.83
3.425E- 0.6997041
0.2290 02 0.2290 3.132E-01 4 70.83
2.544E- 1.0176337
0.1300 02 0.3590 3.387E-01 4 70.83
8.266E- 0.8445592
0.3678 02 0.3678 4.213E-01 3 70.83
7.633E- 1.5129561
0.4065 02 0.7743 4.977E-01 7 70.83
2.213E- 0.4643271
0.2479 02 0.2479 5.198E-01 5 70.83
5.095E- 1.0519629
0.3673 02 0.6152 5.707E-01 5 70.83
 4.772E- 0.4148887
0.2624 02 0.2624 6.185E-01 6 70.83
4.217E- 0.9364990
0.3694 02 0.6319 6.606E-01 8 70.83
-2.709E-
-1.9748 01 -1.9748 3.897E-01 -4.8900125 70.83
4.930E-
0.2965 02 -1.6783 4.390E-01 -3.7036803 70.83
6.447E- 0.7066889
0.3658 02 0.3658 5.035E-01 8 70.83
3.809E- 1.2944903
0.3536 02 0.7193 5.416E-01 9 70.83
6.401E- 0.3922242
0.2431 02 0.2431 6.056E-01 2 70.83
1.036E- 0.5136497
0.0806 02 0.3236 6.160E-01 4 70.83
1.393E- 1.0470549
0.8056 01 0.8056 7.553E-01 9 70.83
5.539E-
0.2758 02 1.0813 8.107E-01 1.3110775 70.83
9.031E- 0.0951217
0.0793 03 0.0793 8.197E-01 5 70.83
5.026E- 0.3842738
0.2604 02 0.3397 8.700E-01 9 70.83
1.097E- 0.1136397
0.1017 02 0.1017 8.809E-01 8 70.83
8.536E- 0.7725199
0.6557 02 0.7574 9.663E-01 7 70.83
1.253E- 0.2241624
0.2479 01 0.2479 1.092E+00 4 70.83
3.165E- 0.3864808
0.1917 02 0.4396 1.123E+00 8 70.83

Table 5 Showing the calculation of Weight age for securities using Sharpe’s single index
formula to arrive at optimum portfolio.
5. CONCLUSION:
It could be concluded by saying that this study helped me in understanding how to get the
relevant data from secondary sources to construct an optimum portfolio using Sharpe’s model. It
is a good experience as it is a learning of getting the required things for calculation from real
time data and applying those data in the calculation. It is not like the problem with all the
required data in it, it is different as we are asked to solve the problem by getting required data
from different sources. So totally it is a great learning experience, of having completion of
assignment with the guidance of professor and friends.

6. BIBLIOGRAPHY:
1. BSE India.com
2. www.economictimes.com
3. www.investopedia.com
4. www.myaccountingcourse.com
5. https://financialmanagementpro.com
6. www.corporatefinanceinstitute.com
7. www.accountingtools.com
8. Financial Management- B.V. Ragunandhan
9. SAPM study material