Problems on sharpe’s optimal portfolio

R i−R f
Excess return to Beta ¿
βi
Where
Ri = expected return on stocks.
Rf = The return on a riskless asset (treasury bill rate)
βi = Beta.

C i=
σm Σ
2
( R i−Rf
σ ei
2
) βi
where,
2 β 2i
1+σ Σ m 2
σ ei
σ2m = Market variance
σ2m = unsystematic risk.

Construction of a optimal portfolio

Xi=
Zi
Σ Zi
where Zi =
βi
σ
2
ei
[( ) ]
Ri−R f
β
−C

C= Cut off ratio

According to CAPM
Ri = Rf + β(Rm- Rf)
Also = α + βRm (To find Ri ; if not given in prob)

1) Vinod received Rs 10 Lakhs from his pension fund he wants to invest in the stock market. The treasury bill rate is 5%
and the market return variance is 10. The following table gives the details regarding the expected return, Beta and
residual variance of the individual security. What is the optimal portfolio assuming no short sales?
Security Expected return Beta σ2ei
A 15 1 30
B 12 1.5 20
C 11 2 40
D 8 0.8 10
E 9 1 20
F 14 1.5 10
 Solution:
Rf = 5%; σ2m = 10

( )
Security Ri−R f Rank
β
A 10 1
B 4.67 3
C 3 6
D 3.75 5
E 4 4
F 6 2

( ) ( )
Security Ri−R f Ri−R f β
2
β
2
Ci Zi Xi %
2
βi Σ 2
βi 2
Σ 2 investment
σ ei σ ei
σ ei σ ei
A 0.333 0.333 0.033 0.033 2.504 0.176 47.43
F 1.35 1.683 0.225 0.258 4.701 0.195 52.57
B 0.525 2.208 0.1125 0.3705 4.693 0.371
E 0.2 2.408 0.05 0.4205 4.626 41.43
D 0.24 2.648 0.064 0.4845 4.530 52.56
C 0.3 2.948 0.1 0.5845 4.307 0.371

n
Cutoff ; C i=σ
2
m ∑ ¿¿¿
i=1
10 (0.333)
C A= =2.504
1+10(0.033)

10(1.683)
CF= =4.701  C*
1+10 (0.258)

10(2.208)
C B= =4.693
1+10(0.3705)

10(2.408)
CE= =4.626
1+10 (0.4205)

10(2.648)
C D= =4.530
1+10 (0.4845)

10(2.948)
C C= =4.307
1+10 (0.5845)

Zi =
βi
σ
2
ei
[( ) ]
Ri−R f
β
−C

1
ZA= [ 10−4.701 ] =0.1760
30
 1.5
ZF= [ 6−4.701 ] =0.1949
10
Σ Z i=0.176 +0.195=0.371
0.176
X A= =47.43 %
0.371
0.195
X F= =52.57 %
0.371
47% invested in stock ‘A’ & 53% in ‘F’

When Ri not given & ‘α’ is given

2) Mr. David is consulting an optimal portfolio. The market return forecast says that it would be 13.5 % for the next
two years with the market variance of 10%. The risk free rate of return is 5%. The following securities are under
review. Find out the optimal portfolio.
Company Αlpha Βeta σ2ei
A 3.72 0.99 9.35
B 0.60 1.27 5.92
C 0.41 0.96 9.79
D -0.22 1.21 5.39
E 0.45 0.75 4.32

Solution:
We have Ri = α + βRm ; Rf = 5%; Rm = 13.5. σm2 = 10%

Company Ri R i−R f Rank

β
A 3.72 + 0.99(13.5)= 17.09 12.21 1
B 0.60 + 1.27(13.5) = 17.75 10.04 2
C 13.37 8.72 4
D 16.12 9.19 3
E 10.575 7.44 5

( ) ( )
Company Ri−R f Ri−R f β
2
β
2
Ci Zi Xi %
2
βi Σ 2
βi 2
Σ 2 investment
σ ei σ ei σ ei σ ei
A 1.280 1.28 0.105 0.105 6.244 0.371 48.37
B 2.74 4.02 0.272 0.377 8.428 0.286 37.29
D 2.50 6.52 0.272 0.649 8.705 0.109 14.21
C 0.82 7.34 0.094 0.743 8.706 0.001 0.13
E 0.97 8.31 0.130 0.873 8.541
0.767

C*= 8.706

3) Create the optimum portfolio by choosing from the following securities and assuming the risk free rate as 8%
and variance of the market index is 12%.
Security Ri β σ2ei (unsystematic Risk)
A 20 1 40
B 18 2.5 35
C 12 1.5 30
D 16 1.0 35
 E 14 0.8 25
F 10 1.2 15
G 17 1.6 30
H 15 2.0 35

Solution:
Security R i−R f Rank
β
A 12 1
B 4 5
C 2.67 7
D 8 2
E 7.5 3
F 1.67 8
G 5.63 4
H 3.50 6

( ) ( )
Company Ri−R f Ri−R f β
2
β
2
Ci Zi Xi %
2
βi Σ 2
βi 2
Σ 2 investment
σ ei σ ei
σ ei σ ei
A 0.300 0.300 0.025 0.025 2.769 0.1791 45.10
D 0.229 0.529 0.029 0.054 3.852 0.0904 22.77
E 0.192 0.721 0.026 0.080 4.414 0.0853 21.48
G 0.480 0.201 0.085 0.165 4.836 0.0423 10.65
B 0.714 1.915 0.179 0.344 4.481
H 0.400 2.315 0.114 0.458 4.276
C 0.200 2.515 0.075 0.533 4.164
F 0.160 2.675 0.096 0.629 3.755
ΣZi =
0.3971

C*= 4.836

4) The cumulated values of Ci start declining after a particular C i and that point is taken as the cut-off point and that
stock ratio is the cut-off ratio C.
This is explained with the help of an example.
Data for finding out the optimal portfolio are given below

Security Number Mean Return Excess Return Beta Unsystematic Risk Excess Return to Beta
Ri Ri – Rf β σ2ei R i−R f
βi
1 19 14 1.0 20 14
2 23 18 1.5 30 12
3 11 6 0.5 10 12
4 25 20 2.0 40 10
5 13 8 1.0 20 8
6 9 4 0.5 50 8
7 14 9 1.5 30 6
The risk less rate of interest is 5% and the market variance is 10. Determine the cut-off point.
 Security R i−R f (R ¿ ¿ i−R f )× β i βi
2 N 2
βi Ci
βi σ 2ei
¿ N
(R ¿ ¿ i−Rf ) β i 2 ∑ σ2
∑ σ 2ei
¿ σ ei i=1 ei

Number 1
i=1 6 7
2 3 5
4
1 14 0.7 0.7 0.05 0.05 4.67
2 12 0.9 1.6 0.07 0.125 7.11
5
3 12 0.3 1.9 0.02 0.15 7.60
5
4 10 1.0 2.9 0.1 0.25 8.29
5 8 0.4 3.3 0.05 0.3 8.25
6 8 0.04 3.34 0.00 0.305 8.25
5
7 6 0.45 3.79 0.07 0.38 7.90
5

Calculations are given below

For Security 1
10 × .7
C 1= =4.67
1+(10 ×.05)
Here 0.7 is got from column 4 and 0.05 from column 6. Since the preliminary calculations are over, it is easy to
calculate the Ci.
10 × 1.6
C 2= =7.11
1+(10 ×.125)
10 × 1.9
C 3= =7.6
1+10 (15)
10 ×2.9
C 4= =8.29
1+10(0.25)
10 × 3.3
C 5= =8.25
1+10 (0.3)
10 × 3.34
C 6= =8.25
1+ 10(0.305)
10× 3.79
C 7= =7.90
1+ 10(0.38)

The highest Ci value is taken as the cut-off points i.e. C*. the stocks ranked above C* have high excess returns to
beta than the cut-off C and all the stocks ranked below C* have low excess returns to beta. Here, the cut-off is
8.29. Hence, the first four securities are selected. If the number of stocks is larger there is no need to calculate C i
values for all the stocks after the ranking has been done. It can be calculated until the C* value is found and after
calculating for one or two stocks below it, the calculations can be terminated.

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 as follows
 Zi
Xi= N

∑ Zi
i=1

Zi = (
β i R i−Rf
2
σ ei βi
−C¿ )
The first expression indicates the weights on each security and they sum upto one. The second shows the
relative investment in each security. The residual variance or the unsystematic risk has a role in determining the
amount to be invested to be invested in each security.
Taking up the previous example
1
Z1 = ( 14−8.29 )=0.285
20
1.5
Z 2= ( 12−8.29 ) =0.186
30
0.5
Z3 = ( 12−8.29 )=0.186
10
2
Z 4= ( 10−8.29 )=0.086
40
N

∑ ¿ 0.285+0.186+0.186=0.086=.743
i=1
0.285
X1= =0.38
0.743
0.186
X2= =0.25
0.743
0.186
X3= =0.25
0.743
0.086
X 4= =0.12
0.743
Thus, the proportions to be invested in different securities are obtained. The largest investment should be made
in security 1 and the smallest in security 4.