RISK AND RETURN OF 2 SECURITIES AS PER SHARPE INDEX MODEL

T. Ronald Callistus 05
Ismail Choudhary 10
Kriselle Dsilva 15
Rahul Jagtap 21
Sumedha Kambli 26
What does Sharpe index model
indicates
Introduction:

Generally Direct proportion between Stock and Index

prices.

This relation estimates the return on stock.

 Limitations Of Markowitz model

Certain assumptions
 Measuring Historical Return
The return on an investment for a given period is:

R = D + (P1 – P0)
P0
Where :
D = Dividend received during the year
P1 = Ending Price of the investment
P0 = Beginning price of the investment

Rate of Return= Total Return * 100

Single Index Model
 A broad stock market index is assumed to be the
single, common factor for all securities

( Ri  T )   i   i ( Rm  T )  ri

i = expected non-market return of securities

i(rmt - T) = expected market return of securities
rit = component of return due to unexpected firm-specific events
Measuring Systematic Risk:
Beta (β) measures a stock’s market (or
systematic) risk.

It shows the relative volatility of a given

stock compared to the average stock.

An average stock (or the market portfolio)

has a beta = 1.0.
Beta shows how risky a stock is if the stock
is held in a well-diversified portfolio.
β=1 → stock has average risk.
β>1 → stock is riskier than average.
β<1 → stock is less risky than average.
β=0 → risk free assets (e.g., Treasury bills)
Calculation of beta
Beta (β)= Covariance (Ri, Rm)
Variance (Rm)
_ _
Covariance (Ri,Rm) = Σ (Ri-Ri)(Rm-Rm)
n-1
_ 2
Variance (Rm) = Σ (Rm-Rm)
n-1
Return classification
Return due to the Market

The return independent of the Market

Different views of securities on
beta value

Aggressive securities

Defensive securities
WHAT ALPHA STANDS FOR???
αi < 0: the investment has earned too little for its risk
(or, was too risky for the return)

αi = 0: the investment has earned a return adequate

for the risk taken

αi > 0: the investment has a return in excess of the

reward for the assumed risk
What is alpha and beta

Rit   i   i Rmt  ri
RISK
var(Ri  T )  var(ri )   im 2 var(Rm  T )

var( Ri  T )  Variance of security I excess return

var(ri )  Variance of non market component of
security I excess return
 im 2 var(Rm  T )  Variance of market
component of security I excess
return
Market and Non market Return:
 Expected value of security i’s excess Return can be
found by,

(i.e. Non Market component + expected value of market component)

Market and Non market Risk:
 In Single Index Model, the total risk of a security, as
measured by its variance, consists of two components: market
risk and unique risk

 i.e. Variance of Non Market component + variance of market component

 Risk is finally square root of variance.

 i.e. risk = √(var(Ŕi))
Companies- BHEL, Mahindra and Mahindra

Calculating-

• Returns of security
• Returns of market using nifty index
• Beta
• Alpha
• Risk
 S&P CNX Nifty
Index for large 50 companies on the

National Stock Exchange of India.

NIFTY is accounting for 22 sectors of the economy.

Used for variety of purposes such as benchmarking fund

portfolios, index based derivatives and index funds.

S&P CNX Nifty is owned and managed by

India Index Services and Products Ltd. (IISL), which is a

joint venture between NSE and CRISIL.
 NIFTY

Year Opening Price Closing Price

2005-06 2067.65 3402.55

2006-07 3473.30 3821.55

2007-08 3633.60 4734.50

2008-09 4739.55 3020.95

2009-10 3060.35 5249.10

 Year Return of NIFTY Deviation N (Deviation N)2
1 2 3=2-AR(N) 4
2005-06 64.56 36.53 1334.79
2006-07 10.03 (18.00) 324.12
2007-08 30.30 2.27 5.15
2008-09 (36.26) (64.29) 4133.23
2009-10 71.52 43.49 1891.36
  140.15   7688.65

Return on NIFTY = Closing Price-Opening Price/Opening Price

Average Return (N) = Return of NIFTY/5

= 28.03
Variance = ∑ (Deviation N)2/n-1
= (7688.65)/(5-1)
= 1922.16

Standard Deviation = (Variance)1/2

= (1922.16)1/2
= 43.84
 Mahindra and Mahindra

Year Opening Price Closing Price Dividend

1 2 3 4
2005-06 505.75 627.05 12.80
2006-07 642.55 780.40 11.90
2007-08 713.50 697.05 11.50
2008-09 650.40 383.65 10.00
2009-10 394.95 541.35 9.50
 Year Return on M&M Deviation M (Deviation M)2
1 2 3 4
2005-06 36.78 17.79 316.33
2006-07 33.35 14.36 206.09
2007-08 9.19 (9.80) 96.12
2008-09 (31.01) (50.01) 2501.12
2009-10 46.67 27.67 765.84
  94.99   3885.51

Average Return (M) = Return of M&M/5

= 18.99
Variance = ∑ (Deviation M)2/n-1
 = 3885.5/(5-1)
 = 971.38

Standard Deviation= (Variance)1/2

 = (972.38)1/2
 = 31.17
 Year Opening Price Closing Price Dividend

1 2 3 4

2005-06 801.65 2241.95 20.32

2006-07 2297.75 2261.35 24.58

2007-08 2154.15 2061.35 15.25

2008-09 1892.20 1510.55 17.00

2009-10 1470.15 2390.65 19.50

 Year Return of BHEL Deviation B (Deviation B)2
1 5 6 7
2005-06 199.99 137.41 18882.39
2006-07 23.00 (39.58) 1566.42
2007-08 10.94 (51.63) 2665.86
2008-09 (3.17) (65.74) 4322.14
2009-10 82.11 19.54 381.77
  312.87   27818.58

Average Return (B) = Return of BHEL/5

= 62.57
Variance = ∑ (Deviation B)2/n-1
= 27818.52/(5-1)
= 6954.63

Standard Deviation = (Variance)1/2

= (6954.63)1/2
= 83.39
STOCK AVERAGE VARIANCE STANDARD
RETURN DEVIATION

M&M
18.99 971.38 31.17

BHEL
62.57 6954.63 83.39

NI
28.03 1922.16 43.84
Covariance M&M and NIFTI
M&M and NIFTY

Product Of Deviation
Deviation M Deviation N (M*N)
1 2 3=1*2
17.79 36.54 649.81
14.36 (18.00) (258.45)
(9.80) 2.27 (22.25)
(50.01) (64.29) 3215.21
27.67 43.49 1203.54
    4787.86
Co-variance of M & N
= Product Of Deviation (B*N)/n-1
= 4787.86 /4
= 1196.97
 β = Co-variance of M & N/ Variance of N
= 1196.97 / 1922.16
= 0.62

Hence security is defensive with less volatility.

CALCULATION OF ALPHA
(Exp.RM-T) = α + βMN (Exp.RN-T)
18.99= α +0.62 (28.03)
 α = 1.61

Hence security is underpriced

 Estimating Non market Risk
Excess
Return on Return on return on Deviation of Non market
M&M NIFTY M&M Return Deviation 2
36.78 64.56 41.65 (4.87) 23.68
33.35 10.03 7.84 25.51 650.96
9.19 30.30 20.41 (11.22) 125.80
(31.01) (36.26) (20.86) (10.15) 103.08
46.67 71.52 45.96 0.71 0.51
    95   904.03
Excess Return on BHEL(RB-T)= αB + βBN (RN-T)
Variance of excess return of M&M
= (Deviation)2/n-1
= 904.03/4
= 226.01

Standard Deviation= (Variance)1/2

= (226.01)1/2
= 15.03
Var (RM-T)= Var(ERM) +βMN2 Var (RN-T)
=226.01+(0.62)2 (1922.16)
= 964.88

STANDARD DEVIATION = 31.06

STOCK EXPECTED VARIANCE STANDARD
RETURN DEVIATION

M&M
18.99 971.38 31.17

BHEL
62.57 6954.63 83.39

NI
28.03 1922.16 43.84
COVARIANCE OF BHEL & NIFTY
Co-variance of B & N
= Product Of Deviation (B*N)/n-1
= 10692.12/4
= 2673.03
Beta Calculation
β = Co-variance of B & N/ Variance of N
= 2673.03/ 1922.16
= 1.39

Hence security is aggressive with high volatility.

(Exp.RB-T) = α + βBN (Exp.RN-T)
62.57 = α +1.39 (28.03)
 α = 23.61

Hence stock is underpriced

 Estimating Non market Risk
Excess
Return on Return on Return on Deviation of Non
BHEL NIFTY BHEL Market Return Deviation 2

1 2 3 4=1-3 5=(4)2
199.99 64.56 113.33 86.66 7509.44
23.00 10.03 37.52 (14.52) 210.95
10.94 30.30 65.7 (54.76) 2998.44
(3.17) (36.26) (26.82) 23.65 559.37
82.11 71.52 122.99 (40.88) 1670.93
    312.72   12949.12

Excess Return on BHEL(RB-T)= αB + βBN (RN-T)

Variance of excess return of BHEL
= (Deviation)2/n-1
= 12949.12/4
= 3237.28
Standard Deviation= (Variance)1/2
= (3237.28)1/2
= 56.9
Var (RB-T)= Var(ERB) + βBN2 Var (RN-T)
 = 3237.28+ (1.39)2 ( 1922.16)
 = 6951.08

STANDARD DEVIATION = 83.37

Risk Component
TOTAL RISK NON MARKET
MARKET(UNSYS (SYSTEMATIC)
TEMATIC) RISK

964.88 226.01 738.87

6951.08 3237.28 3713.28

 Final Table
STOCK RETURN BETA ALPHA NON- MARKET STANDARD
MARKET RISK DEVIATION
RISK

95 0.62 1.61 226.01 738.87 31.08

312.72 1.69 23.61 3237.28 3213.8 83.37

THANK YOU