qwertyuiopasdfghjklzxcvb nmqwertyuiopasdfghjklzxc vbnmqwertyuiopasdfghjklz Construction of Portfolio xcvbnmqwertyuiopasdfghj Using SI Model klzxcvbnmqwertyuiopasdf Security Analysis and Portfolio Management ghjklzxcvbnmqwertyuiopa

sdfghjklzxcvbnmqwertyuio pasdfghjklzxcvbnmqwerty uiopasdfghjklzxcvbnmqwe rtyuiopasdfghjklzxcvbnmq wertyuiopasdfghjklzxcvbn mqwertyuiopasdfghjklzxcv bnmqwertyuiopasdfghjklzx cvbnmqwertyuiopasdfghjkl zxcvbnmqwertyuiopasdfgh jklzxcvbnmqwertyuiopasdf ghjklzxcvbnmqwertyuiopa sdfghjklzxcvbnmqwertyuio pasdfghjklzxcvbnmqwerty uiopasdfghjklzxcvbnmrtyui
8/19/2013 Group 1, Sec A

Contents

SIMPLIFYING THE PORTFOLIO OPTIMISATION PROCESS VIA SINGLE INDEX MODEL

Markowitz Portfolio Theory
Harry Markowitz has developed portfolio model of investment. The model includes expected return, as well as the level of risk related to the return. Markowitz made following assumption on individual's investment behavior to develop his model: 1) An investor chooses the investment with lowest amount of risk if return is equal among given alternatives. 2) An Investors measure the risk on investment in terms of standard deviation or variance on asset return. 3) For each investment, investor can measure investment's expected return & probability of the returns over the time horizon specified. 4) Investors always seek to maximize its utility of investment return. 5) Investors decision is based on risk and return of investment, therefore, investor's utility curve of investor is based on risk & return. In Markowitz' theory, risk of a portfolio considers each investment's risk & return along with investment's correlation with other investments in portfolio.

The Efficient Frontier

Under Markowitz model a portfolio is considered efficient if it gives the investor a higher expected return with the same or lower level of risk as compared to another investment. The efficient frontier is thus a plot of those efficient portfolios,.

The optimal portfolio for any investor is the point on efficient frontier which is tangential to highest indifference curve for investor. However, considering that universe of assets in the world market is very big and so constructing efficient frontier and finding the optimum portfolio is very big problem. The no. of inputs required for MARKOWITZ Model increase very fast with increasing no. of assets under consideration.

Theoretical framework of Markowitz Model

The Markowitz model is used in selection of optimal portfolio Inputs: Ri = return on stock i K = maximum risk factor Covij= covariance between stock i and j N = portfolio size Decision Variables:

5 Xi= fraction of portfolio to invest in stock i Objective: Maximize total returns: Constraints: Budget constraint:

r i x i
i 1

xi 1
i 1

Maximum allowable risk:

K x i cov ij x j N i 1 j 1

These inputs require estimates of the expected return on each stock ri and the possible covariance between each possible pair of stock, i.e. n estimates of returns, n estimates of variance and n(n1)/2 estimates of covariance. So the estimation can get very complex as the portfolio size becomes large. For instance, if the number of stocks in a portfolio are 45, we need to estimate 45(44)/2 = 990 correlation coefficients. For this, Single index model was applied to provide the inputs to the Markowitz model.

SINGLE INDEX MODEL

One of the main components in the inputs to portfolio

analysis is the correlation structure of the stocks. When the number of stocks to select from the portfolio is large, the estimation of variation can get very complex for computational purposes. Single index model assumes that co- movement between stocks is due to the index single model common is influence on the of market following performance. assumptions: i. Most stocks have a positive covariance because they all respond similarly to macroeconomic factors. The based

6 ii. However, some firms are more sensitive to these factors than others, and this firm-specific variance is typically denoted by its beta (), which measures its variance compared to the market for one or more economic factors. iii. Covariances among securities result from differing responses to macroeconomic factors. Hence, the covariance of each stock can be found by multiplying their betas and the market variance: The formulation of single index model can be as follows: i. Mean return of the stock: E (r i ) i + i E ( r m )
2 2 2 2 i = i m + ei

ii. Variance of the stocks return, iii. Covariance ij = i j 2 m of returns

between

stocks:

Where beta is constant that measures the expected change in r i given a change in rm The single index model will need the estimates of mean return, variance of return and beta for each stock, which amounts to 3N+2 = 3* 45+2= 137 inputs, in case of 45 stocks as compared to 990 inputs in normal model. For the purpose of Markowitz model, the mean return of each stock and the market variance is calculated. Finally, beta estimation is done for each stock to calculate the covariance needed in the Markowitz model. However, it is a question whether input provided by Single Index model provide good estimate for Markowitz Model.

OBJECTIVE:
The objective of this study is to test whether inputs provided by single index model gives good estimates for the Markowitz Model.

7 The objective is thus to gain insights on how to develop an effective computational procedure to determine optimal portfolios

Research methodology:

To test whether SI Model correct input for the Markowitz

model, we have made 21 portfolios and tested them for 3 different periods 2007-2009; 2009-2011; 2011-13. Stocks were mostly selected Randomly from various indices, including sector indices, from Indian stock market to make sure data availability and liquidity. We have taken weekly stock price data for 2 years for estimating Beta of the stock. Return on BSE Index has taken as return on market. The risk free rate is taken from RBI database for auction of government security. We have taken average of different rates on government securities for each year, then geometric mean of the two year return related to the corresponding period of analysis. Beta & standard error were estimated using regression between weekly stock return and weekly market return. We calculated covariance from stock weekly return data and then again estimated the covariance using SI Model. Optimization of portfolio was done by maximizing Sharpe ratio and covariance and optimum expected return for each portfolio with estimated data was calculated. A pair wise T-Test was then run on such obtained data on covariance & optimum expected return for Markowitz MeanCovariance model, first by calculating covariance directly and again calculating covariance from estimates by using SI Model to see whether the two methods gives significantly different results or not. Null hypothesis for the test was that difference of mean value is zero. H0: Difference of mean = 0 H1: Difference of mean 0

Finding and analysis

The finding of Paired T-Test is produced below. Mean value of covariance as calculated directly and using SI Model are though different; however they are not statistically significantly different using two tail-tests. However one tail test says that mean value of covariance under Single Index model is significantly high with 5% confidence level, i.e. Single Index model estimates higher covariance for Markowitz model. However using slightly lower significance level both test gives insignificant difference under both kind of tail-test. t-Test: Paired Two Sample for Means of covariance estimate Variable 1 0.0973319 37 0.0042098 99 63 0.0221085 22 0 62
0.04545705 9 1.66980416 3

Mean Variance Observations Pearson Correlation Hypothesized Mean Difference df

P(T<=t) one-tail t Critical one-tail

Variable 2 0.18783455 6 0.16957923 1 63

t Stat P(T<=t) two-tail t Critical two-tail

1.7173108 6 0.0909141 19 1.9989714 98

The paired T-Test for optimum return calculated under two techniques shows a significant difference with 5% significance level. The one tail-test shows a higher estimate of optimum return if inputs from Single Index model is used, i.e. return estimated

9 using inputs from Single Index Model will give a significantly higher return estimates at 5 % confidence level under T-Test. However with 1% significance level the mean estimate from two models are not significantly different and can be concluded that both technique provides equal estimates, significantly not different. t-Test: Paired Two Sample for Means of optimum return estimate Variable 1 0.1762663 12 0.0317853 29 63 0.3695434 8 0 62 2.0574017 15 0.0219298 06 1.6698041 63 0.0438596 12 1.9989714 98 Variable 2 0.23465126 5 0.04773975 5 63

Mean Variance Observations Pearson Correlation Hypothesized Mean Difference df t Stat P(T<=t) one-tail t Critical one-tail P(T<=t) two-tail t Critical two-tail

Conclusion
From the analysis, it is found that inputs used using Single Index model gives the same estimates for covariance and optimum return as with normal calculation of covariance, under 1% significance level for paired T-Test. The result is of very practical use also as in the given vast asset universe, single index model provides a far easy way to find optimum portfolio that is otherwise very difficult & cumbersome to calculate. Thus with validation of

10 single index model as a good estimate for calculating optimum portfolio make cost benefit of finding optimum portfolio. However the observation that slightly higher return is estimated under Single Index model (with 5% significance level) is provides a note of caution that it may lead to overvaluation of Asset prices to some extent.

Limitations and further study

The study was conducted with a limited set of data and

limited period. The market in recent year, especially during the period of study has been very volatile that might have impacted market deviation from the assumptions of Markowitz and SI Models. As is found in beta estimates, the R2 of beta & estimate was very low showing that beta obtained through linear regression is a poor estimate. Market return during many periods have been even lower than risk free return while at the same time risk has been increased due to higher volatility resulting in negative Sharpe ratio for many portfolios which is contrary to theoretical framework and cant sustain in longer run. Selection of index as BSE also may be poor proxy for the market return as it only represents equity market. The equity market has performed very poorly and volatile during the period of study while many other asset classes have, like commodity, performed quite well. This indicates that BSE index might be a poor proxy for the market return and has affected estimation of beta as well. However, in spite of such limitation, result shows encouraging finding. Further study may be taken with broader base and for longer duration and better estimation technique to establish the result.

11 Appendix: Calculation Summary s.n. Actual covariance estimate optimum return with optimum return with covariance as per SI model actual covariance SI model inputs inputs 3.586% 1.943% 8.414% 8.184% 1 4.234% 5.176% 7.599% 7.272% 2 5.774% 0.915% 7.978% 8.160% 3 2.592% 14.687% 8.520% 7.759% 4 5.138% 22.777% 7.546% 6.869% 5 5.053% 1.148% 8.019% 8.205% 6 2.262% 6.120% 8.467% 7.902% 7 3.433% 40.000% 7.659% 6.758% 8 5.841% 0.984% 8.097% 8.172% 9 3.309% 2.768% 7.704% 12.818% 10 4.015% 1.621% 3.550% 21.493% 11 4.228% 5.285% 7.942% 8.111% 12 5.070% 1.802% 7.496% 11.673% 13 5.152% 3.307% 2.374% 25.804% 14 6.091% 0.358% 8.096% 8.312% 15 4.061% 3.588% 7.222% 14.139% 16 5.269% 8.777% 1.025% 41.903% 17 5.711% 8.004% 8.296% 9.674% 18 16.855% 12.346% 12.454% 19 12.714% 11.280% 13.828% 15.448% 20 14.215% 10.845% 8.292% 8.243% 21 10.145% 17.059% 12.212% 13.274% 22 13.315% 16.159% 31.893% 24.465% 23 24.105% 5.786% 5.561% 8.303% 8.265% 24 13.839% 12.842% 12.192% 25 15.284% 20.162% 21.724% 26.464% 26 16.225% 5.347% 6.328% 8.236% 8.225% 27 9.196% 0.715% 9.816% 9.486% 28 4.512% 37.041% 28.354% 29 27.150% 5.181% 0.247% 8.627% 8.587% 30 1.582% 12.229% 12.295% 31 12.643% 5.824% 27.106% 31.716% 32 18.909% 5.934% 0.207% 8.758% 8.492% 33 2.991% 15.258% 13.439% 34 21.076% 4.826% 35.826% 28.534% 35 25.199% 5.181% 0.258% 8.627% 8.603% 36 5.827% 0.963% 15.563% 11.256% 37 24.522% 58.387% 59.166% 38 18.463% 8.102% 2.859% 27.277% 16.275% 39

12 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 4.898% 17.427% 8.895% 5.100% 12.832% 9.631% 16.534% 4.112% 6.572% 11.575% 3.461% 5.200% 12.948% 3.710% 5.863% 6.125% 20.714% 18.598% 5.767% 16.089% 12.287% 5.724% 22.846% 15.463% 1.145% 41.763% 2.952% 0.922% 43.106% 1.578% 51.690% 3.341% 206.071% 59.129% 5.475% 147.660% 40.401% 7.598% 209.014% 0.379% 2.394% 52.996% 0.305% 2.490% 1.481% 0.266% 2.976% 1.372% 15.299% 74.689% 27.925% 14.943% 60.729% 22.677% 59.955% 39.440% -17.684% 47.460% 34.586% -12.656% 49.361% 37.208% -15.322% 8.421% 28.934% 13.507% 8.380% 26.185% 12.117% 8.359% 33.292% 12.476% 11.573% 79.047% 16.396% 11.179% 80.782% 14.240% 49.306% 59.187% 87.096% 52.324% 34.533% 74.904% 44.696% 39.327% 87.763% 8.421% 23.980% 20.948% 8.353% 25.853% 12.102% 8.313% 27.740% 11.799%

Stocks of Random Portfolios

1 2 Hcltech L&T 1 Itc Ltd. Airtel 2 Cairn M&M 3 Gail Maruti 4 Grasim Ntpc 5 L&T Ongc 6 Airtel Bhel 7 M&M Ranbaxy 8 Maruti Tata Steel 9 Ntpc Ultratech 10 Ongc Bpcl 11 Bhel Dr. Reddy 12 13 Ranbaxy Hindalco 14 Tata Steel Axis Bank Asian Paints 15 Ultratech 4 5 6 Cairn United Brew Seasagoa Tcs GailKarnataka Bank Financialtech Ultratech Grasim Quadrant Gail Hcc L&T Wyeth M&M Bhel Airtel Fact Acc Hcl M&M Sunpharma Piramal Reliancec Maruti L N T Ultratech Tatasteel Ntpc Itc Suzlon Jaiprakash Ongc Exide Ucobank Rcommunication Bhel Essar Sail Asian Paints Ranbaxy Yuken Lic Sbi Tata Steel Zodiac Techm Hdfc Ultratech Mrpl Kingfisher Iocl Bpcl Unitech Kotakm Dfm Dr. Reddy Lic LNT Abc Bears 3 7 Asian Paints Tcs Sesa Goa Idbi Lupin Mphasis Relinfra Sail Sci Sun Tv Tatachem Tatamotors Titan Sun Pharma Welcorp

10

11

12

13

14

13
Litl India Hotels Infy Ioc Jsw Steel Gskcons L&T M&M Marico Mindtree Adani Ent Polaris Fin Tech Ptc Reliance Yes Bank Acc Bata India Bpcl Brittania Cairn Cipla Bharatiairtel Lichf Glaxo Godrej Grasim Hindalco Idea Oracle Fin Hero Motors Ashokley Britannia Cipla Dlf Exideind Godrejcp Hdfcbank Hindalco Lupin Marico Mphasis Niittech Pnb Tatamotor Bpcl Cadilahc Dabur Drreddy Glaxo Hcltech Hexaware Icicibank M&M Maruti Mrf Ongc Tcs Ashokley Adani Enterprises Britannia Cipla Dlf Exideind Godrejcp Hdfcbank Bpcl Cadilahc Dabur Drreddy Glaxo Hcltech Allahabad Bank Bharat Forge Havells Indian Hotels Mrf Punj Lyod Sun Tv Tech Mahindra Voltas Realiacne Capital Cesc Aditya Birla Nuvo Aditya Birla Nuvo Ashok Leyland Crompton Greaves Idbi Hexaware Tech Oracle Financials Sail Tata Chem Unitech Syndicate Bank Aurobindo Pharma Adani Enterprises Allahabad Bank Havells

Infy Kotakbank

Upl United Bank Of India

Sbin Hexaware

Icicibank Crompton Greaves

15 16 Allahabad Bank Bpcl Ashok Leyland Cairn Bharat Forge Ultacemc Crompton Greaves Tatapower Idbi Icici Bank Indian Hotels Bankbaroda Hexaware Tech M&M Oracle Financials Heromotoc Sun TvBharatiairtel Tata Chem Zeel Unitech Lichf United Bank Of India Hindcorp Voltas Bomdyeing Aurobindo Pharma Fdc Cesc Ifci

17 18 19 20 21 Hindalco Hindalco Hdfc Tatapow Asianpaints Ongc Bpcl Infosys Icici Bergpaint Acc Tatapower Sbi Bhartiairtel Yes Bank Bajajauto Reliance Indust. Relcap Tata Motors Tata Steel Reliance Icici BankAsianpaints Ajanta Pharma Tata Motors Indust. Infosys Infosys Bergpaint Jppower Ajanta Pharma Itc Bharatiairtel Yes Bank Axis Bank Jppower Hdfcbank Drreddy Tata Steel Gitanjali Axis Bank Asianpaint Hcltech Tatapow Jetair Mrf Petronet Lichf Icici Hul Lupin Lichf Hindcorp Bhartiairtel Mrf Cipla Glaxo GlaxoTata Motors Lupin Mnm Bomdyeing Fdc Ajanta Pharma Cipla Bhel Fdc Ifci Jppower Jsw Steel Jetair Litl Litl Axis Bank Bhel Relcap

References

1. Simplifying the portfolio optimization process using SI model, Yansen Ali, 2008 2. www.moneycontrol.com