Professional Documents
Culture Documents
February 2009
Dr. Hao Jiang
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I. Black-Litterman Model
Step 1: Goldman uses weighted daily data to estimate volatilities and
covariance,, where the weights
g depend
p on the horizon.
These weights in conjunction with a global CAPM yield
equilibrium returns.
Step 2: Perceptions of relative value, momentum etc. yield views on
profitable deviations from equilibrium
p q expected
p returns. Attach
weights to views and combine with CAPM to yield expected
returns.
Step 3: Impose desired target risk/beta level relative to the benchmark.
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I. Black-Litterman Model
Note:
¾ g holds no views,, he will hold the equilibrium/market
If the manager q
portfolio.
¾ If his views have high variance (low certainty), he will hold close to
the equilibirum portfolio.
¾ When his views have low variance
variance, he will move considerably
away from the market portfolio.
¾ This method is useful in that it tells you how to optimally
incorporate your information/views to tilt your portfolio, taking
advantage of the correlation structure to hedge large positions.
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Mathematical Representation
There are N risky assets, with expected returns µ, which is an N×1
variance covariance matrix V,
vector and variance-covariance
vector, V which is an N×N matrix
matrix.
We assume the investor knows V but not µ.
The investor has personal views with which she updates the expected
returns. The investor’s view is given by
P µ=Q+ε,
where ε is normally distributed with means of zeros and variance
matrix of Ω.
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The updated expected return vector is now:
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A Seven-Country Equity Allocation Problem
Portfolio allocation using historical volatilities and assuming
- Equal returns=7% per year [purple bars]
- View:
i German equity will outperform European equities by 5%
per year. Translated into: Germany (+2.5%) and France and UK
(-2.5%) [red bars]
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A Seven-Country Equity Allocation Problem
Here we used equal expected returns. What do you think would
happen if you instead started out with historical average returns?
- You face the same sensitivity issues
issues.
- You end up with putting more weights on assets that performed
well during the sampling period.
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CAPM-Based Estimates (assuming market risk premium=7.15%)
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How to back out equilibrium returns using the CAPM, given the
market weights?
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Suppose we impose the view:
E(rGer)=market cap weighted French and UK returns + 5%
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The optimal allocations are:
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The Black-Litterman Model
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The Black-Litterman Model
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The Black-Litterman Model
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