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You are on page 1of 14

February 2009

Dr. Hao Jiang

1

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.

market

Step 5: Solve constrained optimization to find “MVE” portfolio.

2

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.

3

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.

vector π and

d the

h covariance

i i Σ.

matrix

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.

4

The updated expected return vector is now:

h Ω=0, then

so that h the

h updated

d d conditional

di i l expectedd return becomes:

b

5

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]

6

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.

However returns you can use “equilibrium”

equilibrium

expected returns calculated by the CAPM.

You can then impose your views using the equilibrium returns as

starting point.

7

CAPM-Based Estimates (assuming market risk premium=7.15%)

8

How to back out equilibrium returns using the CAPM, given the

market weights?

9

Suppose we impose the view:

E(rGer)=market cap weighted French and UK returns + 5%

10

The optimal allocations are:

expected, but why do the other weights change?

11

The Black-Litterman Model

France and UK.

The fact that expected returns go up in all countries, incl. UK

and France, is due to the correlation structure.

12

The Black-Litterman Model

structure), the optimal weights are then:

13

The Black-Litterman Model

portfolio plus a weighted sum of the portfolios about which the

i

investor

t has

h views.

i

portfolio, then in the portfolios about which views are expressed.

assets about which no views are held.

views about each and every asset!

14

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