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Lecture 7:

Revisiting The Black-Litterman Model

February 2009
Dr. Hao Jiang

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
Step 3: Impose desired target risk/beta level relative to the benchmark.

Step 4: Impose bounds on desired relative exposure to the market.

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

Step 6: Check solution to see if it is suitably diversified.

I. Black-Litterman Model
¾ g holds no views,, he will hold the equilibrium/market
If the manager q
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.

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
We assume the investor knows V but not µ.

The investor believes that µ is normally distributed with the mean

vector π and
d the
h covariance
i i Σ.

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.

The updated expected return vector is now:

E(µ|views)= π+ ΣPT[PΣPT+ Ω] -1 [Q-P π ].

A simplifying case is the investor is extremely confident in her views

h Ω=0, then
so that h the
h updated
d d conditional
di i l expectedd return becomes:

E(µ|views)= π+ ΣPT[PΣPT] -1 [Q-P π ].

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]

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
- You end up with putting more weights on assets that performed
well during the sampling period.

However, instead of using past returns,

However returns you can use “equilibrium”
expected returns calculated by the CAPM.
You can then impose your views using the equilibrium returns as
starting point.

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

How to back out equilibrium returns using the CAPM, given the
market weights?

Suppose we impose the view:
E(rGer)=market cap weighted French and UK returns + 5%

The optimal allocations are:

The changes in weights for Germany, France and UK are

expected, but why do the other weights change?

The Black-Litterman Model

The imposed view says only that Germany will outperform

France and UK.
The fact that expected returns go up in all countries, incl. UK
and France, is due to the correlation structure.

The Black-Litterman Model

Using these expected returns (internalizing the correlation

structure), the optimal weights are then:

The Black-Litterman Model

Generally, the optimal portfolio equals the (CAPM) market

portfolio plus a weighted sum of the portfolios about which the
t has
h views.

An unconstrained investor will invest first in the market

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

The investor will never deviate from the market weights on

assets about which no views are held.

-- This means that an investor does not need to hold

views about each and every asset!