CONSTRUCTION OF OPTIMAL PORTFOLIO USING SHARPE’S SINGLE

INDEX MODEL - A STUDY WITH REFERENCE TO BANKING AND

AUTOMOBILE SECTOR

* S.SUBASHREE, Assistant Professor, Department of Commerce and Business Administration,

SRM University, Chennai – 600 026, Tamilnadu, India.

** Dr.M.BHOOPAL, Assistant Professor, Department of Management Studies, Manonmaniam

Sundaranar University, Abishekapatti, Tirunelveli - 627 012, Tamil Nadu, India.

ABSTRACT

The main aim of this study is to construct an optimal portfolio using Sharpe’s Single

Index model. For this purpose monthly closing prices of 5 companies from banking sector and 5

companies from auto mobile sector listed in the Bombay stock exchange (BSE) were selected.

Share prices for the period of October 2016 to September 2017 had been considered. Using all

the collected data a “cut-off” rate had been calculated and that rate had been considered for the

construction of optimal portfolio. The finding of the study will be very useful for investors,

policy makers, corporations and their financial market participants.

Key Words: Cut-off rate, Beta, Market Return, Sharpe’s single index model, Systematic Risk,

1. INTRODUCTION

The security analysis and portfolio management is the most concerned aspect for rational

investment and decision making. A portfolio is a set of securities such as stocks, bonds and

money market instruments. The process of blending together these assets classes, so as to obtain

maximum return with minimum risk is called portfolio construction. It is a very difficult task to

find out good investments among various types of investments. In an optimal portfolio every

investor need maximum return with a minimum return. This process is done through the

construction of an optimal portfolio.

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2. STATEMENT OF THE PROBLEM

The present study is prepared on the basis of studying the sectors in which an investor

can invest their savings in a group of securities or portfolio. By creating a portfolio an investor

get maximum return with a minimum rate of risk. Portfolio management deals with the analysis

of individual securities as well as with the theory and practice of optimally combining securities

into good portfolios. So the banking sector and automobile sector had been considered.

Therefore, the present study is entitled as “Construction of Optimal Portfolio using Sharpe’s

single Index model-A study with reference to banking & Automobile Sectors”

3. OBJECTIVES OF THE STUDY

1. To construct an optimal portfolio using Sharpe’s single index model by using the selected

sectors.

2. To calculate the return and risk of the constructed optimal portfolio by using Sharpe’s Single

Index Model.

3. To get a knowledge about Sharpe’s single Index model.

4. RESEARCH METHODOLOGY

This study is based on secondary data obtained from the website www.yahoo

finance.com. Ten companies from the BSE Sensex index were selected for the study. The tools

used are as follows

(a) Estimate the return on stock. The equation to be used

Ri= (Pt-Po) ×100
Po
Where,

Pt=current year price

Po=previous year price.

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(b) Excess return to beta ratio
Beta ratio = (Ri-Rf)
βi
Where,

Ri =the expected return of stock i

Rf = risk free rate of return

βi=systematic risk of stock)

(c) Cut – off Ci is calculated by using the following equation

Where,

σ2m =Variance of the market index

σ2ei=stocks unsystematic risk

5. LIMITATIONS OF THE STUDY

1. Only 10 stocks from two sectors, i.e., Banking and Automobile sectors are taken for

consideration into the study.

2. This studies result may not be universally applicable.

6. REVIEW OF LITERATURE

Dr. S. Poornima, Aruna P Remesh (2015)1 in their research “construction of optimal portfolio

using sharpe‟s single index model- a study with reference to banking & it sector” in this research

10 companies from banking sector and 10 companies from it sector listed in the Bombay stock

exchange (NSE) were selected. Share prices for the period of January 2011 to December 2015.

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Dr. K. V. Ramanathan, K. N. Jahnavi (2014)2 in the study have referred that media and

entertainment sector has been taken into consideration for constructing the optimum portfolio.

Twenty companies like PVR, Sun Network, Inox, Raj television have been selected and the

portfolio is constructed using sharpe optimal index to obtain the optimal and effective portfolio

returns.

Thangjam Ravichandra (2014)3 endeavors to build an ideal portfolio by utilizing sharpe„s

single index model. For this reason, NSE Nifty and all the 50 stocks where are a part of it have

been utilized as business record for planning portfolio for the period of April 2008 to December

2013. S. Devarajan and I. Francis Gnanasekar studied about the construction of optimal portfolio

using sharpe's index model: a comparative analysis of Indian private and public-sector banks in

post global financial crisis period” the study helps to analyze the risk and return of 34 selected

private and public – sector banking stocks which are part of CNX 500 as market index. The

portfolio is constructed using sharpe optimal index to obtain the optimal and effective portfolio

returns.

Desai, Radhika and Surti, Manisha (2013)4 constructed an optimal portfolio using fifty

companies which were listed on the NSE and the time duration of the study is three years.

Among the fifty companies only ten companies were selected for the optimum portfolio. The

proportion of investment made in each security has been calculated using the Sharpe’s Single

Index Model. The volatility of security has been analysed. The research provides direction to

investors regarding performance of securities. Once the performance is analysed and optimum

portfolio of securities is constructed, it enables the investor to take appropriate decisions.

Dileep and Rao, Kesava (2013)5 studied the applicability and utility of the Single Index Model

in the Indian context and also evaluated the performance of the portfolio thus constructed in

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terms of its rate of return. A sample of thirty companies belonging to various sectors was chosen

for study and the data required for this study was collected from secondary sources. It was found

that only four companies were included in portfolio construction. The study concluded that

William Sharpe’s Single Index Model will be sustainable and applicable to the Indian market

where investors can construct a portfolio for improving the expected returns on their investment.

Mandal, Niranjan (2013)6 applied Sharpe’s Single Index Model considering the daily prices of

twenty one securities for the period of ten years i.e. April 2001 to March 2011. In order to

determine the daily market return, the BSE Sensex was taken as the market performance index.

After formulating the cut-off rate, those securities whose Ci values greater than the cut-off point

were selected. Then to arrive at the optimal portfolio the proportion of investment in each of the

selected securities in the optimal portfolio was computed on the basis of beta value, unsystematic

risk, excess return to beta ratio and the cut off rate of the security concerned. Different statistical

tools and techniques charts and diagrams have been used for the purpose of analysis and

interpretation of data. From the samples of twenty one securities an optimum portfolio was

constructed using ten securities. From the study it is observed that the Sharpe’s Single Index

Model gives an easy mechanism for constructing an optimal portfolio of stocks for a rational

investor by analyzing the reason behind the inclusion of securities in the portfolio with their

respective weights.

P. Varadharajan (2012)7 says the construction of equity portfolio of large caps companies of

selected sectors in India with reference to the sharpe index model.in this research 18 stocks from

three different large caps sectors are the risk and return of all the stocks are studied individually.

Based on the study top five stocks are selected for forming optimum portfolio. The final step in

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the process is to determine the number of shares of eac h stock to be purchased. The portfolio is

constructed using sharpe optimal index to obtain the optimal and effective portfolio returns.

P. Varadharajan (2011)8 constructed an equity portfolio (Oil, IT, Steel and Banking Stocks)

with reference to the sharpe index model.The study includes 25 stocks from five different

sectors. Only the secondary data for the past five years (2005 – 2006 to 2009 – 2010) are used in

the study. The final portfolio thus constructed includes stocks from more than one sector. Ch.

Naveen(2014) from have done research on the title “application of sharpe single index model to

BSE” he has selected 30 blue chip companies of BSE with 6 years data i.e. from January 2007 to

December 2012 have been considered. Besides this, an attempt has been made to test the validity

of the sharpe model to construct the portfolio.

7. DATA ANALYSIS AND INTERPRETATION

Secondary data were used for this study. Ten companies listed in the BSE sensex were
chosen. The companies were selected listed below:
Table - 1 Sample Companies Names
S.No Name of Companies
1 Axis Bank
2 HDFC Bank
3 ICICI Bank
4 State Bank of India
5 IDBI Bank
6 Tata Motors
7 Mahindra & Mahindra
8 Hero Moto Corp
9 Ashok Leyland
10 TVS Motors Company
[Source: Secondary Data]

Table 1 shows the list of sample companies selected for the study. First five companies

are from the banking sector and the remaining five from automobile sector.

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 Table – 2 Mean Returns of Sample Companies' Stocks
S.No Name of the Companies Mean Returns in (%)
1 Axis Bank 1.13%
2 HDFC Bank 3.92%
3 ICICI Bank 2.35%
4 State Bank of India 2.02%
5 IDBI Bank -0.25%
6 Tata Motors 0.28%
7 Mahindra & Mahindra 1.34%
8 Hero Moto Corp 2.15%
9 Ashok Leyland 5.03%
10 TVS Motors Company 6.42%
[Source: computed by the author]
Table 2 shows the mean returns of the ten companies selected for the construction of an

optimal portfolio using Sharpe's Single Index Model. This table reveals that TVS Motor

Company has the highest return of 6.42% and IDBI bank has the lowest mean return of -0.25%.

In order to know the market risk face by each security, the beta values of sample companies’

stock returns were computed and tabulated below.

Table - 3 Beta values of the Sample companies' Stocks

S.No Name of the Companies Beta Values
1 Axis Bank 0.54
2 HDFC Bank 0.70
3 ICICI Bank 1.42
4 State Bank of India 0.96
5 IDBI Bank 1.16
6 Tata Motors 2.15
7 Mahindra & Mahindra 0.26
8 Hero Moto Corp 0.918
9 Ashok Leyland 1.50
10 TVS Motors Company 0.390
[Source: computed by the author]
Table 3 shows the beta values of the ten companies’ stock returns. A beta below 1

indicates either an investment in stocks with lower volatility than the market, or a volatile

investment whose price movements are not highly correlated with the market. The Tata Motors

has the highest beta value of 2.15 which means it is highly volatile. Ashok Leyland (1.50), ICICI

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Bank (1.42), and IDBI Bank (1.16) have the beta values greater than 1 which means they are

volatile. Mahindra & Mahindra has the lowest beta value is 0.26 which represents lower

volatility. The beta values were calculated using the following formula:

Σ (Rm - Rm) (Ri - Ri)

βi =
( Rm - Rm)2
Where,
β = beta
Rm = return of market index
Rm = mean of market index
Ri = return of individual stock
Ri = mean of individual stock
Table - 4 Ranking of the stocks based on excess return to Beta ratio
S.NO Name of the Companies Ri Ri-Rf Β Ri-Rf/β Rank
1 Axis Bank 1.13% -5.12 0.54 -9.481 9
2 HDFC Bank 3.92% -2.33 0.70 -3.328 5
3 ICICI Bank 2.35% -3.9 1.42 -2.746 3
4 State Bank of India 2.02% -4.23 0.96 -4.406 6
5 IDBI Bank -0.25% -6.5 1.16 -5.603 8
6 Tata Motors 0.28% -5.97 2.15 -2.776 4
7 Mahindra & Mahindra 1.34% -4.91 0.26 -18.88 10
8 Hero Moto Corp 2.15% -4.1 0.918 -4.466 7
9 Ashok Leyland 5.03% -1.22 1.50 -0.813 2
10 TVS Motors Company 6.42% 0.17 0.390 0.435 1
[Source: computed by the author]
Table 4 indicates that the excess return and excess return to beta ratio. Excess return is

the difference between expected return on the stock and the risk free rate of interest. The risk free

rate of interest is assumed to be 8% in this study. The excess return to beta ratio measures the

additional return on a security per unit of systematic risk. Table 4 shows that the TVS Motors

Company stock has the highest excess return to beta ratio of 0.435 while that of Mahindra &
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 Mahindra stock has the lowest of -18.88. This ratio provides the relationship between potential

risk and reward from a company's stock. The ranking of stocks done on the basis of excess return

to beta ratio reveals that while the TVS Motors Company stock ranks first, the Mahindra &

Mahindra stock ranks the last. In addition to the systematic risk of individual securities, their

unsystematic risk as measured by σei2 is also computed and tabulated in the table 5. It is the

unique risk affecting the firm due to certain factors affecting only the company issuing such

security. It is an avoidable or controllable risk. The companies are listed in this table based on

their ranks.

Table - 5 Cut-off Values (Ci) of sample Companies Stock

S.No Name of the Ri- β^2/(δei)^2 {Ri- ∑{𝐑𝐢 ∑ 𝛃^𝟐 Ci
Companies Rf/β Rf/(δei)^2}/βi
− 𝐑𝐟 /(𝛅𝐞𝐢)^𝟐
/(𝛅𝐞𝐢)^𝟐}/𝛃𝐢
1 TVS Motors 0.435 0.0289 0.01257 0.01257 0.028 2.22
Company
2 Ashok -0.813 1.4884 1.2100 1.22257 1.516 1.24
Leyland
3 ICICI Bank -2.746 15.21 41.766 42.9885 16.72 0.38
4 Tata Motors -2.776 35.640 98.936 141.924 52.36 0.36
5 HDFC Bank -3.328 5.4289 18.067 159.991 57.794 0.36
6 State Bank of -4.406 17.892 78.832 238.823 75.686 0.31
India
7 Hero Moto -4.466 16.81 75.073 313.896 92.496 0.29
Corp
8 IDBI Bank -5.603 42.25 236.72 550.616 134.74 0.24
9 Axis Bank -9.481 26.2144 248.53 799.146 160.96 0.20
10 Mahindra & -18.88 24.1081 455.15 1254.29 185.068 0.14
Mahindra
[Source: computed by the author]
Once the composition of the optimal portfolio is ascertained, the next step is to calculate

the percentage to be invested in each security which is shown in Table 6.

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 Table – 6 Proportion of Investment Proposed
Sl.No Scrip Name Ci Proportion of Investment

1 TVS Motors Company 2.22 57.81

2 Ashok Leyland 1.24 32.29
3 ICICI Bank 0.38 9.09
[Source: computed by the author]
Table 6 represents the proportion of investment to be made in each security. The three

securities ranking from 1 to 3 are selected for the optimal portfolio. The percentage of funds to

be invested in each security is presented in figure 1:

Figure – 1 Proportion of Investment Proposed

Propotion of Investment
TVS Motors Company Ashok Leyland ICICI Bank

10%

32%
58%

The above figure shows the proportion of investment made by the investor. From the

figure we can understand 58% of the investment made in TVS Motors Company, 32% of the

investment made in Ashok Leyland and the remaining 10% of the investment in ICICI Bank.

8. FINDINGS

The findings of the present study are presented below:

1. The TVS Motors Company has the highest return of 6.42% and the IDBI has the lowest

return of -0.25%. If the investor wants to earn a maximum return without considering the

risk aspect then investment can be made on those securities which yield high returns.

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 Even though the return is high, the risk involved in the stock return should be considered

while taking investment decisions.

2. The return from Tata Motors has the highest beta value of 2.15 which means it is highly

volatile.

3. Ashok Leyland, ICICI bank and IDBI Bank have beta values greater than 1.ie.they are

also volatile.

4. TVS Motors Company having the highest cut off value i.e., 2.22 and Mahindra &

Mahindra having the lowest cut off value is 0.14.

5. The three securities ranking from 1 to 3 based on the Ci values were identified along with

the proportion of investment to be made. The proportion of the investment to be made is

58% in TVS Motors Company, 32% of the investment made in Ashok Leyland and the

remaining 10% of the investment in ICICI Bank. This implies that the majority of funds

may be invested on the TVS Motors Company stock.

9. CONCLUSION

Constructing an optimal portfolio is a challenging task for the individual as well as the

institutional investors. This paper made an attempt to construct an optimum portfolio using the

Sharpe’s Single Index Model. Thus the optimal portfolio is constructed by using the Sharpe’s

single index model. This method is more adequate. Portfolio is constructed by taking the past

one year data. After constructing the portfolio only three companies were selected for the

portfolio construction. From banking sector one company was selected and from automobile

sector two companies were selected for optimal portfolio construction.

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REFERENCES

1. Poornima, S., & Remesh, A. P. (2015). Construction of optimal portfolio using Sharpe‟s

single index model-A study with reference to banking & IT sector. IJAR, 1(13), 21-24.

2. Ramanathan, K. V., & Jahnavi, K. N. (2014) Construction of optimal equity portfolio

using the sharpe index model with reference to banking and information technology

sectors in india from 2009-2013. International Journal of Business and Administration

Research Review, 2(3).

3. Ravichandra, T. (2014). Optimal Portfolio Construction with Nifty Stocks.

4. Desai, Radhika and Surti, Manisha (2013), “ Optimal Porfolio Construction: Sharpe’s

Single Index Model”, International Journal of Scientific Research, 2 (9), pp: 250-251.

5. Dileep, S. & Kesava Rao, G.V. (2013), “ A Study on Sustainability of William Sharpe’s

Single Index Model”, IJAMBU,1 (1), pp: 48-54.

6. Mandal, Niranjan (2013), “Sharpe’s Single Index Model & its Application to Construct

Optimal Portfolio: An Empirical Study”, Great Lake Herald, 7 (1), pp: 1-19.

7. Varadarajan, P. & Ganesh (2012), “ Construction of Equity Portfolio of Large Cap

Companiesof Selected Sector in India with reference to the Sharpe Index Model”,

International Journal of Physical and Social Sciences, 2 (1), pp: 37-50.

8. Varadharajan, P., & VIKKRAMAN, D. (2011). A study on construction of equity

portfolio (oil, it, steel and banking stocks) with reference to the sharpe index model.

Chief patron chief patron.

9. Kevin.S, “Securities Analysis and Portfolio Management”, PHI Learning, New Delhi,

2015.

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WEBSITES

1. www.bseindia.com

2. www.moneycontrol.com

3. www.nseindia.com

4. www.yahoofinance.com

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