Vile Parle (W), Mumbai-56

2023-24

FINAL REPORT ON
Financial Planning and Portfolio Management
for NIFTY 50 Index

By
Bhavya Chandra (N219)
Keshav Malpani (N257)
Kartik Saxena (N277)
Vasundhara Shrivastava (N284)
Dhrumil Talati (N288)
Smit Thummar (I238)

Faculty Mentor: Alaknanda Lonare

Abstract:
The purpose of this research study was to estimate the actual returns of the stocks in the
NIFTY 50 index and analyze stock returns using the Capital Asset Pricing Model (CAPM) to
understand if the stocks were undervalued or overvalued according to CAPM. Also we used
Sharpe's Single Index Model to create an optimum portfolio using stocks of NIFTY50
companies. To create the Efficiency Frontier, we also used Markowitz model.
Keywords: Portfolio Construction, Stocks, Nifty, Single Index Model, Assets pricing,
CAPM, Risk-return analysis, Beta, Market risk

Introduction:
Portfolio:
Portfolio refers to a collection of investments held by an individual or institution. These
investments can include stocks, bonds, mutual funds, exchange-traded funds (ETFs), real
estate, commodities, and other assets. The purpose of building a portfolio is to achieve
specific financial objectives, such as capital appreciation, income generation, diversification,
or risk management.
Key aspects of a portfolio include:
1. Asset Allocation: This refers to the distribution of investments across different asset
classes, such as stocks, bonds, and cash equivalents. The allocation is typically based on the
investor's risk tolerance, investment goals, and time horizon.
2. Diversification: A well-constructed portfolio usually contains a diversified mix of
assets to reduce overall risk. Diversification involves spreading investments across various
sectors, industries, geographic regions, and asset types to minimize the impact of any single
investment's poor performance.
3. Risk Management: Portfolio managers assess and manage risk by selecting
investments with varying risk levels and correlations. They aim to achieve an optimal balance
between risk and return, taking into account the investor's risk tolerance and investment
objectives.
4. Return Objectives: Investors typically have specific return objectives, such as
beating the market average, generating income, or preserving capital. The composition of the
portfolio is designed to help achieve these objectives within the investor's risk parameters.
5. Monitoring and Rebalancing: Portfolios require ongoing monitoring and periodic
rebalancing to maintain their desired asset allocation. Rebalancing involves buying or selling
assets to bring the portfolio back to its target allocation, especially when market movements
cause deviations from the original plan.
Overall, a well-managed portfolio reflects an investor's financial goals, risk tolerance, and
investment strategy, aiming to optimize returns while managing risk effectively.
Objective of the research:
1. To calculate the risk and return of selected stocks included in NIFTY 50 and analyze each
stock's systematic and unsystematic risk.
2. To create an efficiency frontier using Markowitz model
3. To apply CAPM model to analyze stock returns in the Nifty 50 index, and determine
whether stocks are undervalued or overvalued to determine whether a stock is risky or less
risky
4. To construct an optimal portfolio using Sharpe’s Single Index model by testing the model
on selected stocks listed in NIFTY 50.
5. To calculate the respective proportion for each selected stock to be invested in the
portfolio.
Markowitz Model:
The Markowitz Model, also known as Modern Portfolio Theory (MPT), was developed by
economist Harry Markowitz in the 1950s. It revolutionized the field of finance by providing a
framework for investors to construct portfolios that maximize expected returns for a given
level of risk or minimize risk for a given level of expected return. The core concept of the
Markowitz Model is diversification.

Here's how the Markowitz Model works:

• Expected Return: The model begins by estimating the expected returns of individual
assets in the portfolio. This involves analyzing historical data, financial statements,
economic forecasts, and other relevant information to determine the potential future
performance of each asset.
• Risk Assessment: Markowitz recognized that investors are generally risk-averse and
seek to minimize the uncertainty or volatility associated with their investments. In the
model, risk is measured by the standard deviation or variance of returns, which
reflects the degree of fluctuation or variability in the asset's performance over time.
The higher the standard deviation, the riskier the asset.
• Correlation: Another crucial aspect of the Markowitz Model is the consideration of
correlations between asset returns. Correlation measures the degree to which the
returns of two assets move together. Assets with low or negative correlations can
provide diversification benefits because they tend to behave differently under various
market conditions, reducing the overall risk of the portfolio.
• Efficient Frontier: Markowitz introduced the concept of the efficient frontier, which
represents a set of optimal portfolios that offer the highest expected return for a given
level of risk or the lowest risk for a given level of expected return. The efficient
frontier is a curve that plots the risk-return trade-off for different portfolio
combinations.
• Portfolio Optimization: Using mathematical techniques such as mean-variance
optimization, investors can identify the optimal portfolio allocation that lies on the
efficient frontier. This allocation involves selecting a combination of assets that
maximizes the expected return while minimizing the portfolio's overall risk.
• Portfolio Rebalancing: The Markowitz Model emphasizes the importance of
periodically rebalancing the portfolio to maintain its optimal asset allocation. As
market conditions change, asset prices fluctuate, and correlations shift, the original
portfolio allocation may deviate from the efficient frontier. Rebalancing involves
buying or selling assets to bring the portfolio back in line with its optimal allocation.
Overall, the Markowitz Model provides a systematic approach to portfolio construction,
allowing investors to make informed decisions based on risk and return considerations. By
diversifying across assets with different risk-return profiles and correlations, investors can
build portfolios that are well-positioned to achieve their financial goals while managing risk
effectively.

Interpretation:
It shows various companies and their weights in two different portfolios: an equally weighted
portfolio and an optimal weighted portfolio. It also shows other metrics such as annual return,
minimum risk weights, and optimal weights.
• An equally weighted portfolio assigns the same weight to each security in the
portfolio. In the example you sent, each company has a weight of 2% in the equally
weighted portfolio.
• An optimal weighted portfolio assigns weights to each security based on some
optimization criteria, such as maximizing return or minimizing risk. In the example
you sent, the optimal weights for each company are shown in the "Optimal Weights"
column.
• Annual return is the total return on an investment over a period of one year. In the
example you sent, the annual return for the equally weighted portfolio is not shown,
but the annual return for each company is shown in the "Annual Return" column.
• Minimum risk weights are the weights that would minimize the risk of the portfolio.
In the example you sent, the minimum risk weights for each company are shown in
the "Minimum Risk Weights" column.
Insights:
• The companies with the highest weights in the optimal portfolio are ITC, ONGC, and
Coal India. This suggests that these companies are considered to be important drivers
of the portfolio's performance.
• The companies with the lowest weights in the optimal portfolio are HDFC Bank,
HDFC Life, and Bajaj Auto. This suggests that these companies are considered to be
less important drivers of the portfolio's performance.
• The annual returns of the companies in the portfolio vary widely. This suggests that
the portfolio is diversified and not overly exposed to any one company or sector.
• The Sharpe Ratio is a measure of risk-adjusted return. A higher Sharpe Ratio indicates
a better return relative to the risk taken. In this case, the optimally weighted portfolio
has a higher Sharpe Ratio than the equally weighted portfolio, suggesting that it offers
a better return for the level of risk.
• The minimum risk portfolio has the lowest risk of the three portfolios, but also the
lowest return. This is a trade-off that investors need to consider when constructing a
portfolio.
Findings:
CAPM Model:
The Capital Asset Pricing Model (CAPM) is a financial model that aims to determine the
expected return on an asset based on its risk and the overall market's return. Developed by
William Sharpe, John Lintner, and Jan Mossin in the 1960s, CAPM is widely used in finance
for estimating the required rate of return for securities and evaluating investment
opportunities. Here's an explanation of how the CAPM model works:
• Expected Return: The CAPM model starts with the premise that investors require
compensation for the time value of money and the risk they undertake by investing in
a particular asset. The expected return on an asset is therefore composed of two
components:
• The risk-free rate: This represents the return an investor could earn with certainty by
investing in a risk-free asset, such as government bonds. It serves as the baseline
return expected by investors.
• The risk premium: This additional return compensates investors for taking on the
risk associated with the asset. The risk premium is calculated as the product of the
asset's beta and the market risk premium.
• Beta (β): Beta measures the systematic risk, or market risk, of an asset relative to the
overall market. It quantifies how much an asset's returns tend to move in relation to
movements in the broader market.
o A beta of 1 indicates that the asset's returns move in line with the market.
o A beta greater than 1 implies that the asset is more volatile than the market.
o A beta less than 1 suggests that the asset is less volatile than the market.
o A beta of 0 indicates no correlation with the market.
• Market Risk Premium: The market risk premium represents the additional return
investors expect to earn for taking on the risk of investing in the overall market rather
than a risk-free asset. It is typically calculated as the difference between the expected
return on the market portfolio and the risk-free rate.
The CAPM formula is expressed as:
E(Ri)=Rf+βi×(E(Rm)−Rf)
Where:
• E(Ri) is the expected return on asset i.
• Rf is the risk-free rate.
• βi is the beta of asset i.
• E(Rm) is the expected return on the market portfolio.
• (E(Rm)−Rf) is the market risk premium.

Interpretation:
Based on the data in the table, highest estimated return is Coal India with an estimated return
of 45.21%. The company with the lowest estimated return is HDFC Bank with an estimated
return of -0.06%.
Observations:
 • The standard deviation is a measure of risk. Companies with higher standard
deviations are considered to be more risky. In the table, Coal India also has the
highest standard deviation (30.82%), which aligns with its high estimated return.
• Beta is a measure of a stock's volatility relative to the market. A beta of 1 means the
stock's price will move exactly in proportion to the market. A beta greater than 1
means the stock's price will be more volatile than the market. In the table, Tata
Motors has the highest beta (1.1414).
• The risk-free rate is the hypothetical return of an investment with no risk. In the table,
the risk-free rate is assumed to be 7.10%.
• The expected return is the return an investor expects to earn on an investment. It is
calculated by adding the risk-free rate to the product of the beta and the market return
expected to exceed the risk-free rate. In the table, the expected return for Adani
Enterpris is 14.83%, the highest value.

Findings:
Sharpe Single Index Model:
Sharpe's Single Index Model, also known as the Single Index Model (SIM), is a method
developed by William F. Sharpe for assessing the risk and return characteristics of individual
assets within a portfolio. It's a simplified version of the Capital Asset Pricing Model (CAPM)
that considers the relationship between an asset's returns and the returns of a broad market
index. Here's an explanation of how Sharpe's Single Index Model works:
• Basic Assumption: The Single Index Model assumes that the returns of individual
assets are influenced by two main factors: systematic risk (market risk) and
unsystematic risk (specific risk). Systematic risk refers to the risk associated with the
overall market, while unsystematic risk pertains to risks specific to individual assets.
• Market Index as Proxy: In the Single Index Model, a broad market index, such as
the S&P 500, is used as a proxy for the market's returns. This market index captures
the collective performance of a large number of stocks and represents the overall
market movement.
• Regression Analysis: To implement the Single Index Model, historical data on the
returns of individual assets and the market index are collected. Then, a regression
analysis is performed to estimate the relationship between the returns of each asset
and the returns of the market index.
• Beta Coefficient: The key output of the regression analysis is the beta coefficient (β)
for each asset. Beta measures the sensitivity of an asset's returns to changes in the
market index. A beta of 1 indicates that the asset's returns move in line with the
market, while a beta greater than 1 suggests higher volatility compared to the market,
and a beta less than 1 implies lower volatility.
Expected Return: 𝐑𝐢 = 𝛂𝐢 + 𝛃𝐢𝐑𝐦 + 𝐞𝐢

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
systematic risk. The unexplained variance is called residual variance or unsystematic risk.

Systematic Risk = βi2 * Variance of market index

= βi2 * σ2m
Unsystematic Risk = Total variance – Systematic Risk
ei 2 = σi - Systematic Risk
Thus, Total Risk = Systematic Risk + Unsystematic Risk
= βi2 * σ2m + ei2
Sharpe’s Optimal Portfolio:
Sharpe had provided 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 /βi
Where,
Ri = the expected return on stock i
Rf = the return on a riskless asset
βi = the expected change in the rate of return on stock i associated with one unit change in the
market return.
The following steps for finding out the stocks to be included in the construction of an optimal
portfolio.
a) First, find the "excess return to beta" ratio () for each stock under consideration
b) Ranking them from highest to lowest
c) Last, proceed to calculate Ci for all the stocks according to the ranked order using the
following formula

d) The cumulative values of Ci begin decreasing after a particular Ci, and that point is
considered the cut-off point and that stock is cut-off ratio

The percentage of funds to be invested in each security can be estimated as follows.

C* = Cut-off point

Calculation of Portfolio Return

Calculation of Portfolio Variance

Calculation of Portfolio Beta

Interpretation:
• Weight of Each Security (Wi): The table shows the weight of each security in the
optimal portfolio. For example, ONGC has the highest weight of 0.13, followed by
Maruti Suzuki (0.10) and M&M (0.08). These weights indicate the relative
importance of each security in driving the overall portfolio performance.
• Beta of Portfolio (0.68): This represents the portfolio's overall volatility relative to the
market index. A beta of less than 1 indicates the portfolio is expected to be less
volatile than the market, while a beta greater than 1 suggests higher volatility.
• Return of Market (0.01235753): This represents the assumed return of the market
index used in the model.
• Systematic Risk (77.54%) and Unsystematic Risk (2.09%): Systematic risk refers to
the portion of the portfolio's risk that cannot be diversified away through
diversification. It is typically associated with market movements. Unsystematic risk,
on the other hand, is the portion of the portfolio's risk specific to individual securities
and can be reduced through diversification. In this case, the portfolio has a high
concentration of systematic risk (77.54%) compared to unsystematic risk (2.09%).
This suggests that the portfolio's performance is likely to be heavily influenced by
market movements.
• Total Risk (8.92%): This represents the total standard deviation of the portfolio's
return, encompassing both systematic and unsystematic risk.
• Return of Portfolio (33.60%): This represents the expected annual return of the
optimal portfolio based on the Sharpe Single Index Model.
Insights:
• The model prioritizes including securities with a high excess return to beta ratio in the
portfolio. This means the portfolio is likely to be concentrated on stocks with the
potential for above-average returns relative to their market risk.
• The high weight of certain stocks (like ONGC) and the high overall portfolio beta
(0.68) suggest the portfolio may be susceptible to market fluctuations.
• The relatively low level of unsystematic risk (2.09%) indicates good diversification
across companies within the chosen market index.
Findings:

Conclusion
Risk-Return Tradeoff: The data suggests a focus on achieving a high potential return
relative to the level of risk taken. Companies like Coal India offer high estimated returns but
also come with higher risk (standard deviation). The Optimal Portfolio constructed using
Sharpe's Single Index Model prioritizes securities with a high excess return to beta ratio,
aiming for above-average returns while considering market risk.
Portfolio Diversification: While the optimal portfolio prioritizes high potential return stocks,
there's evidence of diversification. The low level of unsystematic risk (Sharpe Single Index
Model) indicates the portfolio is spread across companies within the chosen market index,
reducing risk from individual company performance.
Market Sensitivity: The high portfolio beta (Sharpe Single Index Model) suggests the
portfolio's performance is likely to be heavily influenced by market movements. This means
the portfolio's returns could be amplified in both up and down markets.
Data Limitations: The interpretations are based on estimates and past performance, and
model assumptions like single-factor risk explanation (Sharpe Single Index Model) may not
perfectly capture reality.