Members: Deepak Sharma

Manu Sadashiv
Vishwambhar Singh
Shruti Shetty
Manjunath Patil
Keshav Bhat
 Dividend Discount Model

Po = Di / (r – g)
Po = current stock price
Di = expected dividend
r = required rate of return
g = expected growth rate in perpetuity.

 Cons of Growth Model and Discounted Model

 Modern Portfolio Theory or Markowitz Model
 Assets in an investment portfolio should not be
selected individually on each of their merits.
Rather it is important to consider how each
asset in the portfolio changes in price relative
to how every other asset in the portfolio
changes in price.
 Tradeoff RISK vs RETURNS.

 Best diversification strategy

 Two types of RISK

Systematic or Undiversifiable or Market Risk

Unsystematic or Diversifiable or Portfolio Risk

 Markowitz, ‘By actively selecting the

investment instruments an intelligent fund
manager can avoid a certain amount of risk
and still reap the rewards over it’.
n number of returns
n number of variances
(n^2 – n)/2 number covariance calculations; in total
it requires n(n+3)/2 number of calculation.
Institutional Investors with 50 – 70 stocks, and inputs
more than 5000.

Better off with NAÏVE or Amateur Diversification.

 In contrast the premises of Markowitz’s model, Sharpe’s
model favors that an individual securities has relationship
with one common parameter of the market, i.e. index of the
market.

 According to Sharpe’s concept, different securities in the

market do not have any kind of direct relation with each
other; instead, these have a link with the index of the market,
which is representative of the entire market.

 There are stocks(shares) in the market, which show an

upward movement as soon as market moves up and vice –
versa. Certain shares in the market have an opposite
relationship with the whole market. This association of
individual securities with the market is through the stock
index of the market
 Stock index (SENSEX) is representative of the market and
every security has a relationship with this Index. This
relationship can help in estimating and representing the
returns of these securities. Unlike Markowitz, Sharpe does not
believe in one to one relationship, of individual securities.

 This association of individual securities with the index is

represented with the help of ‘beta’ and depending on the Beta
value of the securities, these get classified into following three
types :

 Defensive stock (shares) i.e. beta < 1

 Neutral stock (shares) i.e. beta = 1
 Aggressive stock (shares) i.e. beta >1
 Defensive stock – these are the shares that have beta value
less than 1, which implies that these show a movement in the
return at a slow pace as compared to the movement of overall
market. E.g. if a stock has beta of 0.75 than for every 1%
change in the overall market this will show a movement of
0.75%.

 Neutral Stock – these shares have a beta value of (1) which

has an implication that these have the tendency to make a
movement as good as that of the overall market.

 Aggressive Stocks – such shares have the beta value more

than 1 (beta >1) and these move at a faster pace then the
movement of the overall market. E.g. if beta of a share is 1.45,
then this will show a movement of 1.45% for every 1%
movement in the overall index of the market.
 It is the simplification over the modern portfolio theory given
my Harry Markowitz.

 In this model, it is favored that returns and risk of a securities

can be represented in the form of characteristic line, which
implies the return and risk of securities can be bifurcated into
two :

 Returns and risk on account of market-wide factors –

Systematic Factors
 Returns and risk on account of company-wide factors -

Non-Systematic Factors
 The model also advocated that an individual security is
desirable only when its returns are in excess of the risk free
returns.

 The excess returns of an individual security hold a

relationship with the excess return on the market portfolio.

 In the absence of the market portfolio a representative index

can be used to show this relationship.

 Returns and risk of individual securities fluctuate, depending

upon the fluctuation in the market portfolio/ market index.
This relationship can be used to create portfolio.
The initial & original work of William Sharpe argued that
the return of each individual security has two basic
components i.e., systematic component and non-systematic
component.

Sharpe was of the opinion that each security has an

association with the market portfolio and the return of
security find an association with the return of such
portfolio. In the absence of market portfolio, a
representative index of the market (like BSE Sensex or
Nifty) may be used.
The changes in the return of a security due to this
association are termed as slope of the curve when plotted
on a graph. This association is represented with the help of
Beta.

At the same time, each security has returns on account of

the performance of the company and such returns are
called non-systematic component of return; in technical
jargon this is called Alpha component of the return. This
alpha component represents minimum return from security
when return on market portfolio or its representative index
is zero.
Following concepts are relevant for the model

1) Market Portfolio
2) Systematic Risk
3) Non-systematic Risk
4) Residual Error Returns
 Market Portfolio – It is a portfolio in which all the securities
of the market find exactly the same proportion in which these
have a representation in the overall market capitalization.

Portfolio created like this, represents the movement of whole

of the market and Beta of such market portfolio is always ‘1’.

Such portfolio is the replication of the whole of the market

and moves in alignment with the market.

In the absence of such portfolio, general index of the market,

which is true representative of whole of the market, can be
used.
 Systematic Risk – By systematic risk, we mean the risk that
arises on account of market-wide factors. This risk can never
be eliminated because it is an inherent part of the market and
investment activities. These risk factors affect all investment
avenues. This model assumes that fluctuations in the value of
stock relative to that of another do not depend on the
characteristic of those two securities alone. The two securities
are more apt to reflect a broader influence that might be
described as general business conditions. Relationships
between securities occur only through their individual
relationship with some index. This relationship with the index
is measured with the help of beta. Beta is a sensitivity
measurement, representing volatility of the returns from a
share, given particular changes in the overall market or index
of the market.
 Non-systematic Risk – This is such component of risk, which
is on account of company-wide factors or factors specific to a
particular investment avenue. This part of the risk can either
be eliminated completely with the help of diversification.

 Residual Error Returns – By residual error returns, we mean

the returns that arise on account of extraordinary event
concerning the performance of a company. When these events
are favoring the company, the effect is positive, otherwise it is
negative. Residual error returns are positive when company
declares bonus, merger, diversification or strategic alliance for
the better. It will be negative when a sudden fall in the profits
is observed, restrictions are applied on company or other
negative aspects take place.
  Risk-return' and Sharpe Model
The return of each security is represented by the
following equation:
Ri   i   i  R m  ei
Ri
= Expected return on security
i
= Intercept of straight line or Alpha coefficient
Rm
= Expected mean return on market
ei
= Random error or error term with mean and S.D.
equal to zero which is a constant.
The mean value of (ei) is zero and hence the
equation becomes-
Ri   i   i Rm
The equation has two coefficients or terms. The alpha value is
the value of (Ri), in the equation when the value of (Rm) is zero;
in other words, it is part of return which is realized from the
security even if the market return is zero. This is the non-
market (unsystematic)' component of security's return. The
beta coefficient is the slope of the regression line and as such,
it is a measure of the sensitivity of .the stock's return to the
movement in the market's return. The combined term ( )
 i RmThis is
denote that part of return, which is due to market movement.
the systematic component of the Security's return.
  Returns of Portfolio
For portfolio return, we need merely the weighted
average of the estimated return for each security in
the portfolio. The weights will be the proportions
of the portfolio denoted to each security.
n
R p   (Wi i )   p  R m
Rp =Expected portfolioi 1return
Wi = The proportion of the portfolio devoted to stock
i
n
 p   Wi  i
i 1
 p = Beta of the portfolio is the weighted beta of the
individual securities comprised in the portfolio.

= Value of the Alpha for the portfolio. Portfolio

alpha value is the weighted average of the
p Alpha' values for its component securities,
using relative market value as weight.
 Risk of Portfolio
Risk of the security or portfolio is calculated by
variance in return or standard deviation of
return. Total risk of a security is represented by
2
ei

the following equation.

Total risk = Unsystematic risk + Systematic risk
Variance R i   ei   i   m
2 2 2

Variance R i = Variance of Security's return

 = Unsystematic risk of security i
2
ei
Systematic Risk =  
i
2 2
m

Unsystematic risk = Total variance of security -

Systematic risk
 Variance of Portfolio
n
       Wi  
2
p
2
p
2
m
2 2
ei
i 1
Systematic risk of the portfolio =
  2
p
2
m

Non-systematic risk of portfolio = n

W
i 1
i
2
 2
ei
 Efficient Portfolio
An efficient portfolio is the one, which offers maximum
return for a given level of risk or has minimum risk for
the given level of return. This is identified with the
help of dominance principle. As investors are risk
averse and are rational decision-makers, they always
prefer to accept maximum return by assuming a
particular level of risk. In the long run, only efficient
portfolios are feasible. Under Sharpe's single index
model, an efficient portfolio can be constructed as
follows:
 Constructing the Efficient Portfolio
Model emphasizes that every individual security
must generate positive excess return; this implies that
mean return or expected mean return of a security
must be more than the return from risk-free avenue.
Here, risk-free avenue means an avenue on which an
assured and safe (free from default risk) return is
generated.
According to the model desirability of any security
is directly related to its excess return to beta ratio [(Ri-
Rf)/Beta i ],where Rf is the return on risk free assets.
If securities are ranked by excess return to Beta (from
highest to lowest) the ranking represents the
desirability of any security's inclusion in a portfolio.
The number of securities selected, depends on a
unique cut-off point, such that all securities with
higher ratio of (Ri - Rf)/Beta i, will be included
in the portfolio and all securities with lower ratio will
not be included in the portfolio. To determine which
securities are included in the optimum portfolio, the
following steps are necessary.
 Steps for Creating Efficient Portfolio:
I. Calculate the excess return. to beta ratio for each security.
2. Review and rank from highest to lowest excess return to
beta ratio
3. The optimum portfolio consists of investing in all the
securities, for which excess return to beta ratio
[(Ri- Rf)/Beta i] is greater than the overall cut-off point c*.
The value of c* is the overall cut-off point It is the cut-off
point of the last security included in the portfolio. It is
computed from the characteristics of all the securities that
belong to optimum portfolio. To determine c*, it is
necessary to calculate its value as if there were different
numbers of securities in the optimum portfolio.
 Since securities are ranked from highest "Excess
return to beta" to lowest, securities with individual cut-
off point more than c* are eligible to be included in the
portfolio. All the securities, which have excess return to beta
ratio more than the overall cut-off point are included in
the portfolio. Such portfolio is the efficient portfolio
and generates the optimum return for the risk
category.
For a portfolio of i securities, cut-off point (ci) for each
security is calculated as follows:
 n {( Ri  R f ) /  i }
  [
2
]
m
i 1  ei
2
Cutoff Rate (ci )  n
i 2
1  m   2
2

i 1  ei
 To construct the best portfolio, the proportion of
funds invested in each selected security in the
optimum portfolio is to be calculated, using the
following formula:

Zi
Wi 
 Zi
i Ri  R f
Z i  2  [{ } c ]
*

 ei i
 Conclusion
Sharpe's Model is convenient as compared to the
model of Harry Markowitz. It helps in the creation of
portfolio with less number of calculations as compared
to any other model. In Sharpe's model association of
individual securities/shares with the index of market
is given importance, instead of correlation between
securities. Only those securities are desirable in the
portfolio, which have positive excess return over risk
free return, All the securities for which excess return to
beta ratio is more than the overall cut-off point-are
included in the portfolio. Such portfolio is the efficient
portfolio and generates the optimum returns.
 What Does Sharpe Ratio Mean?
A ratio developed by Nobel laureate William F. Sharpe to measure risk-
adjusted performance. The Sharpe ratio is calculated by subtracting the
risk-free rate - such as that of the 10-year U.S. Treasury bond - from the
rate of return for a portfolio and dividing the result by the standard
deviation of the portfolio returns. The Sharpe ratio formula is:


(Rp - Rf)/

Rp = Expected portfolio return
 Rf = Risk free return

 = Portfolio Standard Deviation

Greater the Sharpe ratio, better its risk adjusted performance has been.
Negative ratio indicates that a risk-less asset would perform better than
the security being analysed.