Sharpe’s Optimal Portfolio
Sharpe’s Optimal Portfolio
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
/ 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 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 govt security or treasury bill.
The steps for finding out the stocks to be included in the optimal portfolio
are given below:
1.
Find out excess return to beta
ratio for each stock under consideration.
2.
Rank them from the highest to
the lowest.
3.
Proceed to calculate Ci
for all the stocks according to the ranked order.
The cumulated values Ci
starts declining after a particular Ci and that point is taken as
the cut off and that stock ratio is the cut off ratio C.
Construction of the optimal portfolio:
After determining
the securities to be selected, 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
Thus, the
proportion to be invested in different securities are obtained.
Optimum portfolio with short sales: the procedure used to calculate the optimal portfolio when short
sales are allowed is, more or less similar to the procedure adopted for no
short sales, except the cut off point concept. At first, the stocks have to be
ranked by excess return to beta. Here, all the stocks are added to the
portfolio. They are either held long or short. All the stocks affect the curt off point. The Z value
has to be calculated for each stock. If the Z value is positive, the stock will
be held long and if negative, will be sold short. Stocks which are having
excess return to beta above C* are sold short.
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