Portfolios Constructed with Cut-Off Points Based on Heteroscadastic Betas and OLS Betas

Abstract

This paper endeavors to build an optimal portfolio by assuming a single-index model, the justification for which is obtained by analyzing the returns of 37 stocks of the Indian stock market from NIFTY 50 using two approaches: Single index model and APT model. Stock prices in the period from April 2008 to August 2016 is considered in this study. The APT model which proved to be a successful model of stock returns for countries like USA fails to produce significant coefficients, which gives an understanding that the Indian capital market is not yet sufficiently developed to identify all information affecting the stock price movements. The Single Index model leads to the decision that the market index is the most important factor in the Indian capital market. This gives an understanding that the Indian investors respond quickly to the publicly disclosed information. The Treynor's ratio is computed for each asset with the beta of single index model. Two variations of betas are considered in this paper. The betas are estimated with OLS model and with the intervention of GARCH effects. The portfolios are formed by defining a special cut off point and the stocks having overabundance of their normal return over risk free rate of return are chosen. The comparative analysis of OLS betas and GARCH betas identifies the best approach for beta computation and our optimal diversified portfolio comprises of 12 stocks chosen out of 37 stocks.