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Original Title: Model Portfolio Optimization

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Develops optimization problem based on constraint of maximizing expected return 1

and minimizing risk

Advantages

1. Academically sound

Issues

1. Sometimes produces returns that are extreme and not intuitive

2. User have to provide a complete set of expected returns for generating

optimal portfolio weight

3. Model risk high due to requirement of absolute values of expected returns

and portfolio weights

4. Markowitz formulation requires expected returns for all components of the

relevant universe which is very exhaustive as PMs tend to focus on small

segments like picking stocks, stocks with positive momentum and identifying

relative value trades

5. Results can be extreme if PMs focus in asset weights and ignore expected

returns

Combines the market equilibrium with additional market views of the user

With inputs in form of views or statements about the expected returns, the model

combines the views with equilibrium producing the set of expected returns of asset

as well as the optimal portfolio weights. It is simply a set of deviations from market

capitalization weights in the direction of portfolios about the expressed views.

Market Equilibrium: Reference Point for Black Litterman Model

The Black-Litterman model starts with equilibrium expected returns. According to

the Capital Asset Pricing Model (CAPM), prices will adjust until the expected returns

of all assets in equilibrium are such that if all investors hold the same belief, the

demand for these assets will exactly equal the outstanding supply. This set of

expected returns is the neutral reference point of the Black-Litterman model. The

investor then can express her views about the markets.

In the Black-Litterman model, a view is a general statement about the expected

return for any portfolio. These views are combined with the market equilibrium

expected returns. In the case when the investor does not have any views about the

1 Expected return means expected excess return over the risk free yield curve

markets, the expected returns from the Black-Litterman model match the

equilibrium, and the unconstrained optimal portfolio is the market equilibrium

(capitalization weights) portfolio. In the case when the investor has one or more

views about the market, the Black-Litterman approach combines the information

from the equilibrium and tilts the optimal portfolio away from the market portfolio in

the direction of the investors views.

Constraints

Expected Returns (multiple views of relative outperformance) In general

portfolio weight increases as expected returns increases

Degree of confidence

The constrained Optimal portfolio BL not very intuitive in these cases

Risk Constraint weights are adjusted by scaling target risk levels with

volatility of unconstrained optimal portfolio

Budget Constraint

Beta Constraint

Advantages

1. Intuitive

2. Systematic approach to demonstrate deviation of users market view from

reference equilibrium

3. Market Capitalization portfolio with equilibrium expected returns provide

optimal portfolios on which views can be superimposed easily

4. Selected views on regions, sector outperformance etc can be easily

incorporated

5. Simplistic way of incorporating views on portfolios using Markowitz

framework rather than working on complete vector of expected returns.

Benefits

1. The unconstrained optimal portfolio is the market equilibrium portfolio plus a

weighted sum of portfolios calibrated with users view

2. As expected the weight of an asset in portfolio increases with positive view in

comparison to one implied by equilibrium

Calculation Procedure

1. There are

portfolio) is

returns:

. The expected

parameter. The equilibrium expected returns are

= w eq . The CAPM

= +

(e)

, where

(e)

is

. The parameter

3. The user has

K N

is a

Q+ (v)

matrix and

is

(v)

-vector, and

, where

is normally

4. The mean of the expected returns is

( )

[ 1 + P ' 1 Q ].

1

=[ ( )1+ P' P ]

1

5. The investor has the world average risk tolerance. The objective of the

investor is to maximize the utility

optimal portfolio is

= 1 /

w =weq + P '

Since the columns of matrix P are the portfolios in the users view, this

means that the unconstrained optimal portfolio is the market portfolio plus a

weighted sum of the portfolios in the users views. The weights for these

portfolios are given by the elements of the vector

1

formula

6. Let

1

P ,Q

and

represent the

model,

p,q

and

expression of shows the additional view will have a positive (negative)

weight if q p > 0 ( q p < 0 ), this corresponds to the case where the

new view on the portfolio p is more bullish (bearish) than implied by the old

expected return . The additional view will have a zero weight if q = p , this

corresponds to the case where the new view is implied by the old expected

returns already. In this case, the new view has no impact at all.

return qk . The absolute value of k is an increasing function of its confidence

level k 1.

Solution for constraints

1. Given the expected returns and the covariance matrix , the unconstrained

maximization problem max w w ww 2 has a solution of w* = ( ) 1

.

2. Given the covariance matrix , the minimum variance portfolio is w(m) =

1 (1), where is a vector with all elements being one.

3. The solution to the risk constrained optimization problem, max w , subject

to ww 2 , can be expressed as * * * ( ) w w w w r = , where w* = ( )

1 is the solution of the unconstrained problem.

4. The risk and budget constrained optimization problem can be formulated as

max w , subject to ww 2 and w = 1 . Its solution has the form w(b) =

aw*+bw(m) , where a and b are chosen in the way both risk and budget

constraints are satisfied.

5. The risk-, budget-, and beta-constrained optimization problem can be

formulated as max w , subject to ww 2 , w = 1 , and wweq = we

qweq , where weq is the market portfolio. The solution to the problem has

the form of w aw bw m cw eq ( ) = *+ ( ) + , where a , b , and c are chosen

in the way all three constraints are satisfied.

Issues

Criticism

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