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Global Portfolio Optimization Author(s): Fischer Black and Robert Litterman Source: Financial Analysts Journal, Vol. 48, No. 5 (Sep. - Oct., 1992), pp. 28-43 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4479577 . Accessed: 04/06/2011 18:45

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the un. The key is ordain large short positions in combiningtwo establishedtenets many assets.2 largeweightsin the assetsof markets with small capitalizations.equilibriumreturnsfor equities.therefore. If the investorhas no particular viewsabout asset returns.in today's spite the obvious conceptual of computerizedworld.the investor can control how strongly a particular view influences portfolio weights. cn LU LU LU z D -J z z Z U 28 Second.to bear little or no relationto the risk. press. or theirabsoluteperformances. and the historicalreturns they often use for this purpose providepoor guides to futurereturns. mathe. These unreasonableresults stem from two well recognized problems. If the investordoes have one or more viewsabout the relativeperformancesof assets.managersregularlyallow quantiwhen inves.have plagued quantitativeasset the straints. the optimalportfolioasset weights and currency positions of standardasset allocation models are extremelysensitiveto the returnassumptions used. models to help optimizethe critical allocation decision.mean-variance optimization of and solu.Thus investors must augment their views with a set of auxiliaryassumptions. Unfortunately. to various types of constraints). First. they are usuallycomfortable making the simplifyingassumptionthattheirobjectiveis to maximize expected return for a given level of risk (subject. The two problems compound each model has no other.he can use the neutral valuesgiven by the equilibriummodel. .expected returnsare very difficultto estimate.in accordance with the degree of confidence with whichhe holds the view. Furthernore.the mod.' solutionto the two problemsthat When investors impose no con. few global investment role in the global allocationpro.In allodeciding on the appropriate cation.This article describes an apreasonablenature of the results proach that providesan intuitive has often thwartedtheir efforts. however. In practice.and the optimalportfolioit genGiventhe straightforward maticsof this optimizationprob. Investorstypically haveknowledgeable views about absolute or relative returnsin only a few markets. often appears among global asset classes re.erates. in most cases.deone might expect that. Copyright 1991 by Goldman Sachs. quantitative attractions a quantitativeapmodels would play a dominant proach.given its sensitivityto the lem. as well as unreasonably (CAPM) Sharpe and Lintner.In particular.A standard optimization model. models almostalways allocation models.Global Portfolio Optimization Fischer Black and Robert Litterman Quantitativeasset allocation models have not played the importantrole theyshould in global portfolio management.framework Markowitz the els often prescribe"corner" tions with zero weights in many capital asset pricing model of assets. requires them to provide expected returnsfor all assets and currencies.and the views the investorwishes to exquiredin measuring largeamountsof moneyinvolved. When constraints of modern portfoliotheory-the rule out shortpositions.bonds and currenciesprovide neutral startingpointsfor estimatingthe set of expected excessreturns needed to drive theportfolio optimizationprocess. the many correlations expected returns. tors have tried to use quantitative in theirassetallocationdecisions.tativemodels to playa majorrole cess.A good part of theproblem is that such models are difficultto use and tend to resultin portfoliosthat are badly behaved. Investors withglobalportfoliosof equities and bonds are generally aware that their asset allocation decisions-the proportions of funds they invest in the asset classes of differentcountriesand the degrees of currency hedging-are the most importantinvestmentdecisions they make. he can adjust equilibriumvalues in accordance with those views.the standard way to distinguishstronglyheld views fromauxiliary assumptions. Thisset of neutral weights can then be tilted in accordance with the investor's views. Considerationof theglobal CAPM equilibriumcan significantlyimprovethe usefulness of thesemodels.

the mean-varianceoptimization used in standardasset allocation models is extremely sensitive to the expected return assumptions the investor must provide. market-capitalization-weightedportfolio that tilts in the direction of assets favored by the investor. equilibrium risk premiums provide a neutral reference point for expected returns. market capitalization weights. loBalance: A measure of how close a portfolio is to the equilibrium portfolio. A set of examples illustrates how the incorporation of equilibrium into the standard asset allocation model makes it better behaved and enables it to generate insights for the global investment manager. *'Risk Premiums: Means implied by the equilibrium model. * Currency Excess Returns: Returns on forward contracts (see formulas in footnote 5).0 turns for all assets and currencies.H VI trate how the equilibrium solves 2lU the problems that have tradition. Why should an investor use a global equilibrium model to help -j make his global asset allocation decision? A neutral reference is a Our approach distinguishes be.uJ plications of the model that illus. in turn. This suggests that the investor may profit by combining his views about returns in different markets with the information contained in equilibrium prices and returns. returns on assets less the domestic short rate (see formulas in footnote 5).. We thus think it is reasonable to assume that expected returns are not likely to deviate too far from equilibrium values. l-Expected Excess Returns: Expected values of the distribution of future excess returns. To that end.e. rather than requiring the investor to have a view about the absolute return on every asset and currency. The expected returns used in our optimization will deviate from equilibrium risk premiums in accordance with the investor's explicitly stated views. Expected excess returns. For example. the risk of a portfolio is measured as the volatility of the tracking error-the difference between the portfolio's rerturns and those of the benchmark. but rather that when expected returns move away from their equilibrium values. In addition. in this article. Our model makes adjustments in a manner as consistent as possible with historical covariances of returns of different assets and currencies. imbalances in marketswill tend to push them back. If a benchmark is defined.z ally led to unreasonable results in D 0 standard mean-variance models. drive optimization analysis.z twveenthe views of the investor ing use of a mean-variance optiand the expected returns that mization model. co We then follow with a set of ap. This. NoNeutral Views: Means when the investor has no views. 80% currency hedged. bonds and currencies with the risk premiums generated by Black'sglobal version of CAPM equilibrium.Glossary *"AssetExcess Returns: In this article. our model gravitates toward a balanced-i.29 z u z . loEquilibrium Portfolio: The portfolio held in equilibrium. The extent of the deviations from equilibrium will depend on the degree of confidence the investor has in each view. the investor can specify views about relative returns and can specify a degree of confidence about each view. allows the model to generate optimal portfolios that are much better behaved than the unreasonable portfolios that standard models typically produce. we start with a discussion of how equilibrium can help an investor translate his 0 rn views into a set of expected re.3 These equilibrium risk premiums are the excess returns that equate the supply and demand for global assets and currencies. our approach allows the investor to specify as many or as few views as he wishes. Our use of equilibrium allows investors to specify views in a much more flexible and powerful way than is otherwise possible.critically important input in mak. Instead. Our model does not assume that the world is always at CAPM equilibrium. *Means: *Neutral Portfolio: An optimal portfolio given neutral views. and will illustrate. and an equilib. w uJ La Neutral Views - *Normal Portfolio: The portfolio that an investor feels comfortable with when he has no views. *Bencbmark Portfolio: Our approach allows the investor to combine his views about the outlook for global equities. As we have noted. which often include large long and short positions unless otherwise constrained. In our model. Equilibrium risk premiums provide a center of gravity for expected returns. The standard used to define the risk of other portfolios. He can use the normal portfolio to infer a benchmark when no explicit benchmark exists. *Equilibrium: The condition in which means (see below) equilibrate the demand for assets with the outstanding supply.

able to state exact expected ex. Germany.5 torically are in some sense neu22.8 16.8 1.3 would have performed best hisBonds 6. however.1 18. negative values.3 21.3 11. problem with this approach is the different levels of risk in ascan he define his optimal portfo. that have 10.2 Equities 18. Again. assumes. there are several period.1 Annualized Mean Excess Return 0. for example.4 -4.0 223.5 6. that an in.might use to construct an optimal The investor might hope that asrencies are overvalued or under.expected returns for each level of Although such preferences are uities. can provide the investor an The historical average approach Of course. the largest position is through August 1991.mean-varianceoptimization mod.7 0.3 2. currency hedgedandin excessof the London interbank very special set of weights that go offeredrate(LIBOR).3 130. The table illustrates how unbalanced the optimal cca monthly returns for the United the frontiers with the portfolios portfolio weights can be.5 Total Mean Excess Return 3. approach is that equal expected that excess returns will equal excess returns do not compenSuppose. they are not neutral at all. Table III shows they prefer assets whose returns equilibrium risk premium. as a neutral reference. Inveslio? Answering this question dem. Most of the risk premiums.9 117. use of other currencies not constrain against shorting has have the same expected excess would give similar results. of course.0 291.portfolios. what happens when we use such are less volatile and less corre0 U In considering this question. and returns as expected excess return lated with those of other assets. The portfolio that does to assume that bonds and equities spective. dollar per. time investors have viewsother naive approaches investors Equal Means feelings that some assets or cur.equal mean approach and the ate neutral reference.1 1.8 0.5 9.2 -0. With no Australia from January 1975 We can make a number of points constraints.5 4.8 4. France.1 -0. we get an unreasonable cess returns for every asset and portfolio.9 5.7 Historical Averages currency. the their advantage. Canada 12. besides equilibrium neutral reference. bonds and currencies. one problem with this appropriate point of reference.2 tions that bear no obvious relation to the expected excess return assumptions. returnson currencies in excess of the one-monthforward are rates. Japan.3 17.9 4.9 Australia 3.that historical means provide very sets of different countries.1 107. We may optimize use historical data on global eq.7 12. In reality. Everythingelse being equal. How then. it is perhaps surprising use a seven-country model with portfolios.7 France Japan UK US.8 15.8 8. Table IV tic to expect an investor to be risk-adjusted equal mean ap. We risk to get a frontier of optimal obvious. suming equal means for returns across all countries for each asset An asset allocation model can We examine some of these-the class would result in an approprihelp them to apply those views to historical average approach.gives an example of the optimal portfolio for this type of analysis.6 -22.2 23.Our third naive approach to detions. Table I shows many risk.we have positive weights in only two of the 14 potential assets. The equilibrium. we assumptions.9 -1.7% risk. The use of past excess returns to represent a "neutral"set of views is equivalent to assuming that the Annualized Standard Deviation constant portfolio weights that 12. in dollars.7 10.S.3 4.when we claim that standard 30 turns and Table II the correla.9 4. others throughout this article. z Table I presents the means and First. views about assets or currencies.3 112.poor forecasts of future returns.S.8 7.7 -1.3 13. January 1975-August 1991* Germany Currencies Bonds Equities Currencies Bonds Equities -20. The sate investors appropriately for vestor has no views.5 many large long and short posi.8 24. short Australianbonds.4 -2.portfolio when they have no valued at current market prices.9 tral. when we take "everything else being equal" to the United Kingdom.their historical averages. but rather are a * Bondandequityreturns U.proach-below. When we constrain shorting. Canada and without shorting constraints.4 about these "optimal" portfolios. with and IV illustrates.2 0. as Table States.return per unit of risk.7 16.4 0.6 such a literal extreme.5 0.2 -0.they illustratewhat we mean Risk-Adjusted Equal Means standard deviations of excess re.1 Currencies 11.3 42.3 5. where the cn LL . short assets that have done poorly and go long assets that have done well in the particular historical rium provides the appropriate Of course. All the results in this article els often generate unreasonable fining a neutral reference point is are given from a U.6 7. But it is unrealis.0 -13.3 21.Table I Historical Excess Returns. These portfolios are typical of those generated by standard optimization models.8 4. tors diversify globally to reduce on onstrates the usefulness of the For example.

05 0.14 0.48 0.29 Canada Bonds Currency 1.21 0.18 0.25 0.05 0.00 0.50 0.4: z tion-that is.01 0.36 0.15 0.33 0.21 0.33 0.12 0.18 0.08 0.06 0.04 0.24 0.02 0.92 0.04 0.16 -0.31 0. are based on what might be called the "demand for assets" side of the equa.49 0.16 0.36 0.14 0.05 0.20 4: z -J risk measure is simply the volatility of asset returns.02 0.56 0. but also more tilities.06 0.17 0.23 0.45 0.35 0.13 0.37 0.52 0.18 0.48 0.01 0.52 0.05 0.09 0. Currencies in this case are assumed to have no excess return.74 0.42 0.00 0.43 0.13 0.20 0.27 U LU LU 1. But there is another problem as well-perNow we have incorporated vola.10 0.58 0.00 0.04 0.10 0.12 0.12 0.04 0.09 0. and the others we z have so far used.11 0.66 0.13 0.16 0.27 0.82 0.Table II Historical Correlations of Excess Returns.24 0.61 0.19 LU 0 1.03 1. January 1975-August 1991 Germany Equities Germany Equities Bonds Currency France Equities Bonds Currency Japan Equities Bonds Currency UK Equities Bonds Currency Us France Currency Equities Bonds Currency Equities Japan Bonds Currency Bonds 1.21 0.42 0.05 -0.00 0.18 0.26 0.00 0.28 0.14 0. is no better.31 0.32 0.20 0.18 0.00 0.03 0.04 0.21 0.40 0.25 1.15 -0.09 0.03 0.34 0.14 0. Bonds Currency Equities Bonds 1.24 0.03 0.24 0.20 -0.50 0.07 0.12 0.18 0.05 1.00 0.00 -0.22 0.17 0.37 0.06 0.00 0.17 0.07 United States Equities Bonds Equities 1.62 -0.02 0.00 0.35 0.24 -0. Table V shows the optimal portfolio for this case.54 -0.66 0.22 0.28 0.28 1.23 0.22 0.50 0. The problem with such approaches is obvious 31 .20 0.27 0.05 0.27 0.11 -0.15 0.21 0.02 0.23 0.09 0.10 0.10 0. One problem with this approach is that it hasn't taken the correlations of the asset returns into account.32 0.27 1.05 1.33 0.37 0.36 0.00 0.05 1.46 0.19 0.00 0.28 0.19 0.18 0.09 0.41 0.15 0.15 0.23 0.27 Australia Equities Bonds Canada Equities Bonds Currency Australia Equities Bonds Currency United Kingdom Equities UK Equities Bonds Currency US.00 0.12 0.10 1.08 0.33 0.33 0.00 0.07 an Equities Bonds Canada Equities Bonds Currency Australia Equities Bonds Currency 1.48 0.31 0.24 0.19 0.00 0. This approach. but the portfolio behavior serious.21 0.09 0.62 0.33 0.00 1.10 0.haps more subtle.04 1.20 0.00 0.04 0.07 0. historical returns and risk measures.47 0.23 0.06 1.09 0.05 0.05 0.00 0.02 0.09 0.00 0.00 0.17 0.11 0.25 0.00 0.04 0.01 1.02 0.02 0.10 0.11 0.06 0.39 0.

7 40. we feel that universal hedging values between 75% and 85% are reasonable.6 13.2 risk.8 Exposure (%) Bonds (%) Equities (%) 7.5 0. with centage of foreign currency risk weights 80% and 20%.4 -4.0 0.3 -28.1 0.0 0. Table V Optimal Portfolios Based on Equal Risk-AdjustedMeans Germany France Japan Currency Exposure (%) Bonds (%) Equities (%) 5.1 9.0 0.0 4.0 0. Prices and expected excess returns in such a world would have to adjustas the excess Table IV Optimal Portfolios Based on Equal Means demand for one asset and excess supply of the other affectthe marGermany France Japan UK US.6 19.0 0.0 0.9 20.8 -13. Equities (%) 4. the only sensible definition of neutral means is the set of expected returns that would "clear the market" if all investors had identical views.0 rency risk up to the point where the additional risk balances the expected return.0 88.6 -2.4 Unconstrained -12.4 -40.6 21.0 0.5 of the world market portfolio.9 32.2 14." The basic idea is that. -160.0 -44.4 44.0 -12. ev.0 0.7 46.4 6.0 and the average across all pairs of countries of exchange rate volatilWith Constraints Against Shorting Assets ity.8 -4.5 -95.hedging" for this equilibrium.4 54.6 20.6 54. bonds and currencies is similar. while the latter corresponds to a risk premium of 9. the percomprises two assets.1 -32.2 -4.9 8. Canada Australia stant"-depends on three averages-the averageacross countries Unconstrained of the mean return on the market Currency -78.2 23.Bonds (%) 0.3 0. we will use The Equilibrium Approach To us. Canada Australia ket. primarily because the risk premium on the market portfolio is a difficult number to estimate.0 19.0 0.0 19.9 4.6 -20.8 23.5 13.9 15.0 8.2 world as "Siegel's paradox.9% on U.8 23.2 Currency -8.4 -1.7 0.0 22.9 9.8 -1.0 Currency 18. although currencies do raise a complicating question. Under certain Suppose the market portfolio simplifying assumptions.3 9.3 z -j U z 32 32 This result arises because of a 12.2 portfolio of assets.0 0. The concept of equilibrium in the context of a global portfolio of equities.3 -14. Canada Australia -50.4 -10. with identical investors all vestors of different countriesholding the same views and both giving rise to the name "universal assets having equal volatilities.2 -4.6 15.8 0.8 curiosity known in the currency 12.0 0.2 -2. Investors will accept cur- -6.0 7. Nevertheless.5 -11.9 -47.S.0 115.0 0.4 -0.5 65. For this article.3 0 : LU m LU F0) LI. investors worldwide will all want to take a small amount of currency risk.0 0.0 27.6 UK US.1 z ax: D 0 Unconstrained 11.7 10.6 0.5 28.0 7.0 -23. the average Exposure (%) across countries of the volatility Bonds (%) 30.7 -52.0 17. How much currency hedging takes place in equilibrium? The answer is that. Exposure (%) each will gain some expected re.5 .5 13.5 -25.7 -14.2 15.In a simple hedged will be the same for inworld.7 77.0 0.3 turn by taking some currency Equities (%) 11.7 -18.0 0.0 0.8 0. eryone cannot hold equal weights of each asset.5 ra on cx: LL m 0 Currency Exposure (%) Bonds (%) Equities (%) With Constraints Against Shorting Assets -11.0 0.0 0.6 -0.1 37.9 sure returns in different units.0 -5.2 -18.0 0. the former value corresponds to a risk premium of 5.Table III Optimal Portfolios Based on Historical Average Approach The equilibrium degree of hedging-the "universalhedging conGermany France Japan UK US.8 Currency Exposure (%) Bonds (%) Equities (%) 14.0 7. equities.9 0. when we bring in the supply side of the market.1 9.8%.9 -4. in a global equilibrium. In our monthly data set. because invesWith Constraints Against Shorting Assets tors in different countries mea21. It is difficult to pin down exactly the right value for the universal hedging constant.

To see why this is so important.28 Australia 0. 1.32 Canada 0.74 6.3 0.9 0.28 10.1 33 .0 -3.0 0. given this value of the universalhedging constant. The advantageof incorporating a global equilibUnconstrained riumwill become apparent when Currency -6.9 between investor views on the one hand and a complete set of expected excess returns for all assets on the other-is not usually recognized.0 28. We have alreadyseen how difficult it can be simply to translate no views into a set of expected excess returnsthatwill not lead an asset allocationmodel to produce an unreasonableportfolio.Table VI Equilibrium Risk Premiums (% annualized excess returns) Germany France Japan Currencies Bonds Equities 1.4 -13.87 7. views represent the subjective Considerwhathappenswhen we feelings of the investoraboutreladopt these equilibriumrisk pre.88 8.5 U z z We should emphasize that the distinction we are making Bonds (%) Equities (%) 0. he rency risk hedged.27 US.In our approach. the problem is that optimal portfolio weights from a mean-variance Table VIII Optimal Portfolios Based on a Moderate View model are incrediblysensitiveto minor changes in expected exGermany France Japan UK US.3 1. over the next three months.7 1.should be able to express the lios on the frontierwith different differences.9 0.ative values offered in different miums as our neutral means markets.3 8.As we will useful. the investor may feel one less of this portfolio. the equilibriumallows the a neutralframework investor investorto express his views this the can adjustaccordingto his own way.0 13.63 1. instead of as a set of exviews.60 2.3 0.6 35. the economic recovery in the United States will be weak and bondswill performrelatively well and equities poorly.3 29.8 well-behavedportfolios. and constraints. marketwill outperformanother.6 15. 80% hedged.7 6.3 1. Or he may feel bullish (above By itself.without requiringthe investorto express With Constraints Against Shorting Assets a completeset of expectedexcess 9.5 -30. Other portfo.Currency Exposure plete set of expected excess re.3 112.10 2.40 2.4 an investor's views to generate Bonds (%) Equities (%) 3. Considerwhat can happen when this investornow tries to express one simple.72 UK 0.54 7.7 0. optimization objectives pected excess returns.3 27. using equilibrium premiumsas risk the neutralmeans.2 2.Mostviews are relative.2 14.3 5.45 an equilibrium valuefor currency hedging of 80%. The investor'sview is not very strong.4 2.7 6.9 6. Andif some of his views are more simply the market-capitalization portfolio with 80% of the cur.6 23.01 2. levels of risk would correspond to combinationsof risk-freebor.6 translatetheir views into a com.Bonds (%) (%) 2.9 -42. Exposure (%) Australia 0.1 2.0 -3. Suppose the investor's view is that.0 2. examFor rowing or lending plus more or ple.9 1.10 an investordoes not If when we haveno views.strongly held than others.It is he should not have to state one.5 Exposure (%) we show how to combine it with 6.6 24.He is comfortable with a portfoliothathas market capitalizationweights.27 1.S.0 D z -J -0.48 1.4 -1.8 16. the U.3 -3.3 0.0 Currency returns.the equilibriumconcept neutral) or bearish (below neuis interestingbut not particularly tral) about a market.6 0.29 6. Table VI gives the equilibrium risk premiums for all assets.3 4.and he quantifiesit by assumingthat. we start by illustratingthe extreme sensitivity of portfolio weights to the expected excess returnsand the inability invesof tors to expressviews directlyas a completeset of expectedreturns.0 13.1 r'i 0) 0a oL LU m LU L1J Australia -1.Its real value is to provide show.0 0.3 8.23 8.0 1.TableVII havea view abouta given market. As we will show here.6 a basis for portfoliooptimization.6 0. Canada tive asset allocationmodels must 1.9 5. extremely modest view.91 3.7 8.0 5.4 turnson assetsthatcanbe used as Equities (%) 2. benchmarkbond yield will drop 1 basispointratherthanrise Table VII Equilibrium Optimal Portfolio Expressing Views Investorstrying to use quantitaGermany France Japan UK US.0 1. Canada cess returns. shows the optimalportfolio. But suppose thatthe investorhas alreadysolved that problem.over the next three months.

The optimal portfolio weights do shift out of U. We assume this information is known to all. ith asset. we assume the degree of uncertainty about E[Z] and the E[vi]s is proportional to the volatilities of Z and the vis themselves. we Afterthis illustration.8 percentage points and the expected excess returns on U. For example.information about the future re1.The ex. 3.we think about representing that z tion about future excess re. more complex features.We can express this model as follows: We are not assuming that the world is in equilibrium (i. the expected excess return of asset A. the investor starts with expected excess returns equal to the equilibrium risk premiums and adjusts them as follows.12 are a function of the equilibrium risk premiums. will apply it in the contextof our sevencountry model. rather than to rise the 3. equity into U. of asset excess returnsis turns of A relative to B. asset A to outperform asset B by returns for all assets is one of its cc Z = the common factor. given by: is = E[RA] 7TA + yAE[Z]+ E[vj. as is consistent with the equilibrium risk premium. it is not a function of the circumstances of any individual investor. Three-Asset Example Let us first work through a very In addition. It arises because there is a RB = 7rB + YBZ + VB. given this view. of pectedexcess returns the assets of data drawn from the distribu34 LU Note the remarkable effect of this very modest change in expected excess returns. We interpret such a view to mean the intuition behind our apthat the investor has subjective z proach.statement of the form: "I expect few views into expected excess z set of Z. E[RA]. equities down by 2.determined by the relative im.S. The lack of apparent connection between the view the investor is attempting to express and the optimal portfolio the model gener. but the implemencan tationof the approach lead to some novel insights. Because the uncertainty in the mean is much smaller than the uncertainty in the return itself. example. All other expected excess returns remain unchanged. The above description captures the basic idea. as might be expected.5 percentage points. the covariancema.RA = 'TA + YAZ + VA) ates is a pervasive problem with standardmean-varianceoptimization. the expected value of the common factor. To implement the asset allocation optimization. we assume that each investor provides additional inViews with Market . share prices to rise only 2. the investor expects U. but the model also suggests shorting Canadian and German bonds. complex interaction between expected excess returns and the vol.RC= 'TC+ YCZ+ VC. UJ Combining Investor 0 R.11 Similarly.We will now show how a relativeview about two assets can influence the expected excess return on a third asset. B and C. Here is to the ith asset..pacts of the common factorand information is to act as if we had a turns-investor views and the independentshocks.S. which we write as E[RA].1 basis point."where Q is a given value. We do assume that the mean. We assume that both sources of informationare uncertainand are best exdistripressedas probability butions.7% over the next three months. We choose expected excess returnsthatare as consistent as possible with both sources of information.S. For mium on the ith asset. The excess return for each of these assets is known to be generated by an equilibrium risk premium plus four sources of risk-a common factor and independent shocks to each of the three assets. The portfolio weights change in dramatic and largely inexplicable ways. one type of view is a How our approach translates a yi = the impact on the ith as. In this world. Suppose we know the true structure of a world thathas justthree assets.S.summary statistic from a sample market equilibrium.S. We believe there are two trix. This implies that E[RA] distribis uted with a covariance structure proportional to E. and the expected values of the independent shocks to each asset. bonds. E. that E[Z] and the E[vi]s are equal to zero). Table VIII shows the optimal portfolio.3% consistent with the equilibrium view. One way U z distinct sources of informa. but also vi = the independent shock one of its most innovative. Our is uncertainty about E[RA] due to our uncertainty about E[Z] and the E[vi]s. and Q. bonds up by 0. He moves the annualized expected excess returns on U. Furthermore.e. r will be close to zero. The equilibrium risk premiums together with rX determine the equilibrium distribution for expected excess returns.wi = the equilibrium risk pre.formation about expected excess Equilibrium returns in the form of views. -J . = the excess return on the LU simple exampleof our approach. We will refer to this covariance matrix of the expected excess returns as rY.is itself an unobservable random variable whose distribution is centered at the equilibrium risk premium. 2.A. atilities and correlations used in where: measuring risk.

the distribution futurereturns of where we now interpretP as a or as determining. differencebetween the means of 7B' 7r} We wish to calculate a the excess returnsof A and B.where w = {WTA. Canada 0.35 Equities 6. we conditional mean as our vector of proach is used to think about LU can representthe view as a linear expected excess returns.70 2.39 1.3 10. case. we use this dent. subjective views. rY.4 z -J on the equilibriumand this information.3 US. We can write are given and e is an unobserv= same result.6 3.where PandQ .22 0.15 The formula for the exwe can express the view directlyas a tion for E[R]. E[RA1 this restriction as a linear equa.40 2.subject to P *E[R]I= Q.0 Australia 0. mean 0 and diagonalcovariance which is the solution to the prob.73 0. normally distributed ranIn both approaches.we can thinkof a view as representUS Germany France UK ing a fixed number of observaJapan Canada Australia tions drawnfrom the distribution Currencies 1. we Bonds 2. data in the means of the random compo. the number view.42 5.)T draws from the future distribu1(E[R].RBfrom these fidence in a view.47 of futurereturns.44 1.In this case.5 2.or thatthe deviaan unboundednumberof obser. simplify.e. E[RA]. In this special case.resentingeach view are indepen.. In this special case.4 3. the same fromeitherperspective.j.4 2. we use the Black-Litterman approach. depending on which ap.though. We might think (E[R]. -1.3 0.39 3.considerthe lim. can think of the view as directlyreflectinga subjective distribution for the extion of future returns.39 3.0 3.T .3 France 1. In this whichallwe were able to observe nents.28 7.5 29.7 2.and e is a normallydis-[ I P -1 V. matrix.in the second. We have the equilibrium distribu.For the special case of 100%con.32 1.In the more general case where ing InvestorViews With Equilibrium we are not 100%confident. the resulting much weight to give to the view where P is the vector [1.[P .and where the av. we can compute the distributionof E[R] = {E[R. . In the limit.We can thinkof this de.UJ datais Q.matrix fQ. in the first case.86 4. the vector of views can be of observations we havefrom 77" + Ty. mean converges to the condiwhen combiningit with the equitionalmean describedabove.). It conditional distribution for the In either approach. E[RJ} conditional Table X Optimal Portfolio Combining Investor Views With Equilibrium Germany 1.3 1.28 1.0 vations from the distributionof the meansof the distribution repfuturereturns.83 4.in the end we get the turns satisfy the linear restriction P*E[RI' Q + s.7) of this as the case where we have tion of returns. To assume a normaldistribution for z z Currency Exposure (%) Bonds (%) Equities (%) 67. tions of expected returns from .pt].p.lem of minimizing spondsto the assumption the that iting case: The investor is 100% views represent independent sure of his view.14 Alwe ternatively. The appendix H restriction on the expected excess returns-i.UJ erage value of RA. A diagonal fl correIn our example. We use P *E[R]' = Q.3 35 . E[RB]. librium.5 UK 2.4 7.TableIX ExpectedExcessAnnualized PercentageReturnsCombin. this measure to determine how as Q goes to zero. we tion in the expected returns:13 dom variablewith mean 0 and need a measureof the investor's variancefl.1 2.E[RBI = Q. Alternatively.69 3.. 0O.I that representedby P *E[R]'= Q + . This is a relatively straightforward problem from multivariate statistics.expected returns.we assume doesn'tmatterwhich of these ap.pected excess returns. given in the appenis the differencebetween the returnsof A and B.which is given by pected excess returns vector is probability distribution for the Normal (w. subject to the thatthe view can be summarized proaches we use to think about restriction that the expected re.8 1. +Q the standard deviation of the tributed random vector with probability distribution.71 7.9 Japan 7.tion has the following mean: When there is more than one ing.E[RB] Q.58 follow the "mixed estimation" strategydescribed in Theil.29 2. fl representsthe unconfidence in his views.by a statement of the form = our views.able.The conditional normal distribugree of confidence as determin.dix. in certainty the view.

In this case. indeed.0 2.8 5.1 structure that generated the cova0~ riance matrix of returns. exceeds that of B by more than it does in equilibrium. we clearly ought to impute that a shock to the common factor is the most likely reason A will outperNow consider our example.6 3. that the percentage equilibrium risk This time.16 1. (r 19.156 0.31 6.6 0.2 29.85 1.7 Currency 16. 1.9 10.3]. 1991 Benchmark Bond Yields Three-Month Horizon Expected Future Yields Annualized Expected Excess Returns 1.0 3. 1.7 108. the implication for E[RB]is negative relative to equilibrium.3.7 5.0 4.0 6.1 1. ities approximately in the ratios Let the I matrix be as follows: 3:1:2. for simplicity. 1.volatilityof A is associated with its conditional mean.0 14.66 8.03 9.928 6.0 11.Equities (%) -2.0 Suppose the equilibrium risk premiums are again given by [1. Suppose.7 -51.8 -12. we will not is [3. yA. Here the implied effect of the common-factor shock on asset C is lower than in the previous case. LU .0 3.3 9.9.0 2.68 gives the formula for the expected excess returns that combine views with equilibrium in the general case. virtuallyall of the volatility Exposure (%) z of the assets is associated with Bonds (%) 34. 1.790 -7.14 8. Indeed. 1. the values of raised the expected return on C But suppose the by 1. and the expected return of A 0) LU m LU U [9.5 1.5 36 tor.2 6.9]. The impact of the independent shock to B is expected to dominate. Suppose further that the independent But now suppose the indepenshocks are small.8 -3.3 -35.2 16.4 -3.640 -6.151 1. the covariance matrix is as follows: own independent shock. for example.2 0.285 1.5 -65. the invesknow the impacts of the factor on tor's view of A relative to B has the assets-that is. from the impact of one common The conditional mean in this case factor.61 137.6 6.000 1. From this.3 -22.050 -4. In this ex68.688 1. There is a set of VI D :: market capitalizations for which -J that is the case. 1]. 0.7 8. the impact on C should be less than in the previous case.1 -3. [1.9 percentage points. even though the contribution of the common factor to asset B is positive.9.0 10.impact than the common factor.0 6. 2.0 we assume that we know the true 6.0 2.48 5.2 8.31 9.78 10. the conditional mean is [2.4 Z ample.0 6.1 2. 1991 Current Spot Rates Three-Month Horizon Expected Future Spot Annualized Expected Excess Returns Interest Rates July 31. 2].48 11.2 10. so that the assets dent shocks have a much larger are highly correlated with volatil. in form B.3.0] Note that we can identify the impact of the common factor only if 0 3. but it will not be true in Assume also.13. however.9 3. The computation of the premiums are equal-for exam.743 1.6 0.3 141. C ought to perform which asset correlations result better than equilibrium as well. r-J Table XII Optimal (Unconstrained) Portfolio Based on Economists' Views U z Now consider what happens when the investor expects A to Germany France Japan UK US Canada Australia : outperform B by 2%. That is true here. In general. does z ple.0 -8. We may attribute most of the outperformance of A relative to B to the independent shocks.5 -5. more than half of the general.Table XI Economists' Views Germany France Japan UK US Canada Australia Currencies July 31. Although we should impute some change in the factor from the higher return of A relative to B.77 1.0 1.4 79. If so. 1].3 movements in the common fac. yB and yYc unknown values are [3.324 -8. Now assume the investor expects that A will outperform B by 2%.

the ferentialof 5. what hapWe startby illustrating pens when we put a set of stronger views. TableIX shows the complete set of expected excess returnswhen confidencein a view we put 100% [9.E[RB])has a mean of 2 and a variance of 1. bonds and portfolio and limit the risk relaawayfrom U. bonds will outperformU. Canada -0.0 over bondswill be 2.2 Japan -10.above we had to specify the levels directly. Given such strong views on so many assets. bonds to outperform U.given our view.1 1. as it was originally: is Anotherdifference thathere we specify a differentialof means. generate we a ratherextreme portfolio.0 26. matrix of returns.equi.S.5].0 6.We resist using such artificialconstraints.7.4 Currency turns on U. bonds versus U. we find that the conditional mean is given by: [3. Seven-Country Example H Now we will attempt to apply our LU view that bad news about the U.3 25.S.3 26.ances return and risk across all lier. We might say (E[RA].1 3.S. Using the formula folio associatedwith this view. These happento have interestrate been the short-term and exchange rate views expressed by GoldmanSachseconomistson July31.assets. Because the investor has less confidence in his view.8 -2. but only on the covariance U.S.An alternateresponse when the ties.9 accordingly. stocks to the actual data.sonablybalancedportfoliois obsider reasonable. Canada Australia -J UK Germany France Japan say something about expected re-7.3 -34.S. 1.5 -21.S. equities. and optimizing without constraints. determine lettingthe equilibrium the actuallevels of means.6 24.equities.optimal portfolio seems too exbehaved optimal portfolio that tremeis to considerreducingthe expresses that view.0 2. The critical difference between our approach here and Table XIV Optimal Portfolio With Less Confidence in Certain Views z our earlier experiment that generated Table VIII is that here we US. 0L Exposure (%) equities and we allow all other Bonds (%) -2.9 42.S.only the returns U. the expected relative return of 2%for A . 1991.9 -10.4 Australia -17. Finally.0 3. which is closer to the equilibrium value of 0. conditional mean is based on an Table X shows the optimalportuncertain view. in a way thatleads to a well. This makes sense if the is objectiveof the optimization to Controlling the Balance managethe portfoliorelativeto a of a Portfolio benchmark.into our model.3 1.6 22. solve for the expected excess returns on all assets.9 2.We see here a balancedport. 2.6 -13. Before we adjusted Analystshave tried a number of approaches to ameliorate this problem. to not depend on this special knowl.2 -10.1] 2.shown in Table XII. In this sec.8 -4.0 percentage pointsbelow the equilibriumdifIn this example.1 7.9 0. holding fixed all other expected excess returns.2 tion we focus more specifically on the concept of a "balanced" portfolioand show an additional featureof our approach: Changes in in the "confidence" views can be used to controlthe balanceof the optimalportfolio. We are uncomfortIn the previoussection.16 We put 100%confidence in these views.bonds and edge. given in the appendix.S.5 expected excess returns to adjust Equities (%) 6.S.S.9 -3. shown in TableXI.B is reduced to a value of 1. and the covariance matrix of returns is.We now tive to the benchmark untila reaobtain a portfolio that we con. us to express a view that U.4 28.Table XIII Optimal Portfolio With Less Confidence in the Economists' Views Germany Currency Exposure (%) Bonds (%) Equities (%) -12.7 UK -6.0 that the differentialof expected 1.0 -0. z economy will cause U. and find the optimalportfolio.5 percentagepoints.4 1.0 6. we illus.2 7.3 25.0 excess returns of U.3. let's look at the case where the investor has less confidence in his view.Others specify a benchmark zations toward U.S.able when it is used simply to tratedhow our approachallows make the model betterbehaved.3 2.S.6 4.1 US. tained.0 19.0 0. however. There will also be a smaller effect of the common factor on the third asset because of the uncertainty of the view.6.6 7.confidenceexpressedin some or a') co LU ax .8 -6.When asset weights run the up againstconstraints. folio in which the weights have tilted away from marketcapitali. portfoThese results contrast with the lio optimizationno longer balinexplicableresults we saw ear. Some put constraints on manyof the assetweights.8 France -3. equities 4.1 2.

0 4.7 22. The distance measure we use is the volatility of the difference between the returns on the two portfolios. plicit.5 0.the portfolio vis-a-vis the benchfidence in our views of interest mark.0 32.0 1. the more balanced his portfolio will be. minimum-risk portfolio. We have specified higher confidence in our view of yield declines in the United Kingdom and yield increases in France and Ger- on LU Lii cL/ Many portfolio managers are given an explicit performance benchmark. We put less con.2 2. it represents the ment objective.5 2. In mean.0 3.4 1. If an explicit performance benchmany. his risk is clearly related to the stance of his portfolio relative to Benchmarks the portfolios of his competitors. These are not the biggest mark exists.0 1.the measurable liability is only a variance optimization.0 Japan 7. Canada 2.0 Australia 5.0 2.0 55.performance objective is less exmal portfolio shown in Table XIII. In these types of situaunit of portfolio risk. represents the liabilities. to use the volatility of excess reThis is equivalent to having no turns as the measure of risk. portfolio was the interest rate de. In many cases.3 1. Suppose an investor does not have equal confidence in all his views.Table XV Alternative Domestic-Weighted Benchmark Portfolio Currency Exposure (%) Bonds (%) Equities (%) Germany 1.0 0.5 2. then the appropriate yield changes that we expect.0 H- Table XVI Current Portfolio Weights for Implied-View Analysis Germany Currency Exposure (%) Bonds (%) Equities (%) 4. when we folio manager may feel his objecput less than 100% confidence in tive is to perform in the top rankour views. one that represents 30. but measure of risk for the purpose they are the forecasts that we of portfolio optimization is the most strongly want to represent volatility of the tracking error of in our portfolio. One of the most important.4 0.4 -J 0 z France 3.0 Australia 0. the optimal portfolio for this case. or to defining the second is to specify a "normal" benchmark as a portfolio 100% portfolio. we generate a set of expected excess returns that more strongly reflect equilibrium. In our approach. the our views.0 0.0 France 1. The inves. a global equity portcline in Australia.3 UK 2.0 1.small part of the total investment tive is to maximize return per objective. This pulls the optimal portfolio weights toward a more balanced position. When we put equal confidence in For many portfolio managers. the objec.0 US.5 3. and the asset allocation deThe view that dominated that cision is therefore more difficult. for any given level of risk there will be a continuum of portfolios that maximize expected return depending on the relative levels of confidence that are expressed in the views.0 2.tions. by the ambiguity of the investIn other words. such as a marketcapitalization-weighted index. all of the views. The less confidence the investor has. When an explicit benchmark In many investment problems.0 UK 3. Table XIV shows explicit performance benchmark. more confidence in some views Although he does not have an than in others. we obtained the opti. The first is of the portfolio's excess returns.5 0. the market-capitalization portfolio with 80% of the currency risk hedged.2 US.5 1.For example. an alternative benchmark is called for. By putting less confidence in our views. attempts to use quantitative tor's benchmark defines the point approaches are often frustrated of origin for measuring this risk.5 10. we have relatively ings of all global equity managers. Table XIII shows the optimal portfolio that results when we lower the confidence in all of our views. influences on Other examples are an overthe asset allocation decision is the funded pension plan or a univerchoice of the benchmark by sity endowment where matching which to measure risk.Now.9 Japan 2.0 38 13. however.0 0.0 invested in the domestic shortterm interest rate. If the investor is willing to rank the relative confidence levels of his different views. In this case. We define balance as a measure of how similar a portfolio is to the global equilibrium portfo- lio-that is. the model will move away from his less strongly held views more quickly than from his more strongly held ones. then he can generate an even more powerful result.And for a manager funding rate moves in the United States a known set of liabilities.5 1. the appropriate benchmark portfolio and Australia.0 5. two alternativeaprisk is measured as the volatility proaches can be used. does not exist. The benchmark. We find this property of balance to be a useful supplement to the standard measures of portfolio optimization. expected return and risk. Canada 2.7 . but often overlooked.

13 -0. it is often useful to startan analy.82 -0.we assume a port.22 0. or (2) the Views Relative to the Market-Capitalization Benchmark domestic-weighted alternative 2.24 4.5 z -j u z Implied Views Once an investor has established his objectives.tinue to be used in this context ferentviews for a given portfolio.61 4. 80% hedged. model establishes a correspon. The optimal portfolio in equilibrium is marketcapitalization-weighted and is 80% currency hedged. Quantifying the Benefits the desired allocation of assets in the absence of views.01 1.76 2. A pension fund wishing to increase the domestic weight of its portfolio to 85%from the current market capitalization of 45%.45 1. for example.01 maynot have a clearidea of what 0.Ratherthan treatinga strate a substantialbias toward model as a blackbox. turns are of virtually value in futureexpectedexcess projecting In this type of analysis.03 -0.55 Currencies shown in TableXV. relativeto those of for define the direc. then. hasbeen particularly true in the United States.22 -0.48 5.83 5.20 5.20 0.4 percentage points higher than and an expected excess return 30 basis points below those of the optimal portfolio.TableXVII Annualized Expected Excess Returns Implied by a views of the portfolio shown in Table XVI. This versification.49 2.30 2.85 Bonds -0. UK Canada Australia ket-capitalization-weighted Germany France Japan folio. sis by using a model to find the that investment advisers have implied investorviews for which startedto questionthe traditional an existing portfolio is optimal arguments supportglobal dithat relativeto a benchmark. simplybecause investmentadvisTable XVII shows the implied ers argue there is nothingbetter Table XVIII The Value of Global Diversification (expected excess returns in equilibrium at a constant 10.7%and an annualized volatility of 10.8 17.30 -0.72 5. tions of the investor'sviews.Historicalanalyses conbenchmarksmay imply very dif.58 0. we can find the noted in our earlierdiscussionof expected excess returns for neutral views.01 0.and not wishing to hedge the currency risk of the remaining 15% in international markets. a marportUS. he -1. Such a portfolio might. be designed with a higher-than-market weight for domestic assets in order to represent the domestic nature of liabilities without attempting to specify an explicit liability benchmark.18 0.50 0.27 1.14 4. The weights. many recent quantitative use studieshave documenteda rapid successfulportfoliomanagers the a model to investigate nature growth in the international comIn of this relationship.14 3. tic portfoliosin recentyears. might consider an alternative portfolio such as the one shown in Table XV. It has an expected excess return (using equilibrium risk premiums) of 5.90 0.76 106 84 85 49. The pension fund may or may not feel that its preference for domestic concentration is worth those costs.where global portfolios have has folio manager a portfoliowith tended to underperform domesweights as shown in Table XVI.different returns.56 4.30 Bonds folio managerhas thought care5. alternatively.82 Equities is fullyaboutwhathis benchmark are andwhere his allocations relViews Relative to the Domestic-Weighted Benchmark ativeto it.24 Equities views his portfoliorepresents.72 0.88 5.15 3. and has conductedthe 0. For example.63 5.38 -1.45 0.9 z 39 . By tors is the prospective returns assets.01 0.whatmatters inveshis benchmark.It is perhapsnot surprising. the historicalreno which the portfoliois optimal. an asset allocation Bonds Only Equities Only Bonds and Equities With Currency Hedging 2. The higher domestic weights lead to an annualized volatility0. ponents of portfoliosworldwide. and as degree of from international assumingthe investor's risk aversion.63 1.given that the benchGiven Portfolio (1) markis.7%.Unlessa port1.72 4.97 -0.28 2.01 6.21 -1.Of course. An equilibrium model can help in the design of a normal portfolio by quantifying some of the risk and return tradeoffs in the absence of views.1 15. domestic assets.5 17.54 Currencies 0.05 type of analysisshown here.73 4.of Global Diversification dence betweenviews andoptimal While most investors demonportfolios.9 16. particular.7% risk) Domestic Wlthout Global Currency Basis-Point Difference Percentage Gain CN a' Lr 0a U 0 m LU LU LU ~: z 0 D -J Hedging Bonds Only Equities Only Bonds and Equities 2.83 2.50 49 76 74 22.

relatively compa.u the portfolio volatilities at 10.month. Our simulations of all three strategies use the same basic methodology. We suspect that an important benefit of international investment that we are missing here is the freedom it gives the portfolio manager to take advantageof a larger number of opportunities to add value than are afforded by domestic markets alone. promote or justify a particular strategy. from a U. our views are based on the assumption that the expected exOur purpose is to illustrate how a cess returns from holding a forquantitative approach can be eign currency are above their used to make a useful compari. the gains to currency hedging are clearly more important in both absolute and relative terms for fixed income investors. 80% hedged. It requires a set of views. low. the same data and the same underlying securities. or a portfolio manager with both bonds and equities. We normalize . and that has performed quite well We calculate the excess returns in recent years. .strategies and compare them with egy of investing in high-yielding one another and with several pascurrencies with two other strate. they are simple.to measure the value of global diversification. an equity portfolio and 0 U a portfolio containing both bonds 0 and equities (in each case both with and without allowing currency hedging). and any simulation is a test not only of the model but also of the strategy We then optimize the equity. dard investment approaches. we use data up to that point in time to estimate a covariance matrix of returns on equities. to optimize such a strategy. The strategies differ in the sources of views about excess returns and in the assets to which those views are applied. We would suggest that there is something better. we will compare the cess returns for each of the three historical performance of a strat. We are not trying to that currency.forward discount (which. straints on the portfolio weights. However. In we compute the cumulative exparticular. In the absence of currency views. we are also assuming that markets are efficient and therefore we are neglecting to capture any value that an international portfolio manager might add through having informed views about these markets.At the end of 10 years. gies-(1) investing in the bonds The views for the three strategies of countries with high bond represent very different informayields and (2) investing in the tion but are generated using simequities of countries with high ilar approaches.equilibrium value by an amount son of alternative investment equal to the forward discount on strategies. are also substantial. Startingin July 1981 and continuing each month for the next 10 years. There are some limitations to using this measure. and representative of stan. produce investment strategies.although much smaller as a percentage of the excess returns of the domestic portfolio. Historical Simulations U What is clear from this table is that global diversification provides a substantial increase in ex40 pected return for the domestic z z It is natural to ask how a model such as ours would have performed in simulations. It assumes that there are no extra costs to international investment.S.dollar perspective. because of covered interest rate parity. We use the equilibrium concept here to calculate the value of global diversification for a bond portfolio. A reasonable measure of the value of global diversification is the degree to which allowing foreign assets into a portfolio raises the optimal portfolio frontier. add views according to the particularstrategy. egy. A natural starting point for quantifying this value is to compute it based on the neutral views implied by a global CAPM equilibrium. thus relaxing the constraint against international investment cannot make the investor worse off. LU LU m LLI z L#) -J bond portfolio manager. bonds and currencies. our approach does not. bond and currency weights for a One strategy that is fairly well given level of risk with no conknown in the investment world. in itself. All the simulations use our approach of adjusting expected excess returns away from the global equilibrium as a function of investor views. In simulations of ratios of dividend yield to bond the high-yielding currency stratyield. We compute the equilibrium risk premiums. in measuring the value of global diversification this way.sive investments.7%-the volatility of the marH ket-capitalization-weighted portfolio. we test a strategy by performing the following steps. These results also appear to provide a justificationfor the common practice of bond portfolio managers to hedge currency risk and of equity portfolio managers not to hedge. At the end of each month. is to invest funds that would have accrued in that in high-yielding currencies. Be.We have chosen to focus For example. producing the views.is 1% and the rable. In each of the simulations. The gains for an equity manager. we show how a quantitative we update the data and repeat the model such as ours can be used calculation. both in absolute and percentage terms. and calculate the set of expected excess returns for all securities based on combining views with equilibrium. Table XVIII w shows the additional return available from including international Z: assets relative to the optimal domestic portfolio with the same degree of risk. On the other hand. if the equilibrium on these three primarily because risk premium on yen.

July 1981 .S. lIBOR / S.August 1991 with high yields. if the equilibrium risk premium on equities in a given country is 6. the appropriate FiguresA and B show the results graphically. 5/ V 4- (N LU cn / UnhedgedE wGlobal For example.5 with a world averageratioof 0. In simulations of a strategy of investingin equity marketswith high ratios of dividend yield to bond yield.0% and the dividendto bond yield ratiois 0. then we assume the expected excess return on yen currencyexposures to be 3%.Figure A compares the cumulativevalue of $100 invested in each of the three strategies as well as in the equilibrium portfolio.-'85 June-'86 Sept-'87 Dec.-'90 June-'91 approximately equals the difference between the short rate on yen-denominated deposits and the short rate on dollar-denominated deposits) is 2%.thenwe assumethe expected excess returnfor bonds in that country to be 3%.We compute expected excess returnson bonds and equities by adjustingtheir returns awayfrom equilibriumin a manner consistent with 100%confidence in the currencyviews.S. For example. We computeexpected excess returns on currenciesand equities by asconfidencein these suming 100% P4 4 GlobalHedged ^Equilibrium z 0 / 2- / Bond Strategy 2U. we generate Figure B HistoricalRisk/Return views by assumingthat expected excess returns on bonds are 10abovetheirequilibrium valuesby an amountequalto the difference 9 Currency Strategy between the bond-equivalent 8 yield in thatcountryand the global market-capitalizationEquity Strategy weighted average bond-equivaU.4.it cannot easily convey the tradeoffbetween risk and return that can be obtained by takinga more or less 500 r Currency Strategy Equilibrium 400 1 300- 200 - Bond Strategy 00 0u June-'81 Sept-'82 X t ~~~~~~~~~~Equity Strategy| Dec. Bonds z -J U 0- 0 2 4 6 8 10 12 14 16 z Risk (%) 41 . if the equilibrium riskpremiumon bonds in a given countryis 1%andthe yield on the 10-year benchmark bond is 2 percentage points above the world average yield. U.We compute expected excess returnson currencies and bonds by assuming 100%confidence in these views for equities and adjusting rethe turns away from equilibriumin manner.-'88 Mar. Equities U 6 lent yield. then we assumethe expected excess return for equities in that countryto be 11%.which is a global market portfolio of equities and bonds. S. with 80% currencyhedging.-dollar-based perspective $ 600 global market-capitalizationweighted average ratio of dividend to bond yield. we generateviews by assumingthatexpectedexcess returnson equities are above their equilibriumvaluesby an amount equal to 50 times the difference between the ratio of dividendto bond yield in thatcountryandthe In simulations of a strategy of investingin fixed income markets Tradeoffs.While the graphgives a clear pictureof the relativeperformances the of differentstrategies.-'83 Mar. The strategies were structuredto have riskequal to thatof the equilibriumportfolio. views and adjusting returnsaway in fromequilibrium the appropriate manner.Figure A Historical Cumulative Monthly Returns.S.

2. we use E[R] as the vector of expected excess returns."8 ranking of confidence in different views. or perhaps to reconsider. Figure B makes such a comparison. For some academic discussions of Wi = AWjcl We have learned that the inclusion of a global CAPMequilib4 z rium with equities. . The resulting distribution for E[R is normal with a mean E[RI: E[R]= [(72)-1 + Pf-V1P]-1 lrH + P'0 . suggest some interesting lines of inquiry. The secinsights that quantitative modelond distribution represents ing can provide-will stimulate the investor's views about k linear combinations of the elinvestment managers to consider. this issue. "WhenWill Mean-Variance Efficient Portfolios Be Well Diversified?"Journal of Finance.. W." Review of Financial Studies 4 (1991). The first as well as their absolute perfordistribution represents equimance. n assets-bonds. it allows us to Ul distinguish between the views of 4 :D the investor and the set of ex4 pected excess returns used to 4 drive the portfolio optimization. 3. E[R]. March 1952.. It is aswhich views are expressed most sumed to have a probability strongly in the portfolio. Wis as follows: If asset i is a bond or equity: Mi r54 Wi= 0) 0) cl: LLJ If asset i is a currency of the jth Footnotes country: 1. bonds and currencies can significantly improve the behavior of these models.is unobservable. 2. .. 16-22. We hope that our series of examples-designed to illustrate the where r is a constant. This distinction in our approach z allows us to generate optimal 4portfolios that start at a set of neutral weights and then tilt in 42 the direction of the investor's LU LL L/. "PortfolioSelection. In particular. C Green and B. together with the risk/return positions of several benchmark portfolios-domestic bond and equity portfolios. a strategy of investing in highyielding bond markets has not added value. the risk/return tradeoffs obtained by combining the simulation portfolios with cash are linear and define the appropriate frontier for each strategy. Grauer. In portfolio optimization." Review of Eco- .. 8. 5. .Ty. These views plication of such modeling to are expressed in the following form: their own portfolios. The equilibrium-risk-premidence in his views.J.aggressive position for any given strategy. Marketweights of the n assets are given by the vector W = {W1. equities and currencies-are indexed by i = n. "On the Sensitivityof Mean-Variance Efficient Portfolios to Changes in AssetMeans: Some Analytical and Computational Results. Conclusion Quantitativeasset allocation models have not played the important role that they should in global portfolio management.. 4. The expected excess return. Although past performance is certainly no guarantee of future performance. see R.I LU r-J Fz 0~ where Wjc is the country weight (the sum of market weights for bonds and equities in the jth country) and A is the universal hedging constant. R." Journal of Finance. We show each frontier. the equilibrium portfolio and global market-capitalization-weighted bond and equity portfolios with and without currency hedging..6. For bonds and equities. Similarly. where 5 is a proportionviews influence the portfolio ality constant based on the forweights. By adjusting the confi. and ? is an unobservable normally distributed random vector with zero mean and a diagonal covariance matrixQ.n.by specifying a mulas in Black. . j Lintner. we believe that these results. What we find is that strategies of investing in high-yielding currencies and in the equity markets of countries with high ratios of dividend yields to bond yields have performed remarkably well over the past 10 years.1Q]. the investor ums vector HIis given by Hl = can control how strongly the 8K:W. We define the PE[R] = Q+ Here P is a known k *n matrix. By contrast. Appendix 1. Q is a k-dimensional vector. pp. We suspect that a good part of the problem has been that users of such models have found them difficult to use and badly behaved. and M j Best and R. it is centered at 1I with a covariance matrix r-. forthcoming. [(. Because the simulations have no constraints on asset weights. H Markowitz. librium.. the investor can control 7. Assets' excess returns are iven by a vector R= R1. Hollifeld. "TheValuation of RiskAssets and the Selection of RiskyInvestments in Stock Portfolios and Capital Budgets. the apements of E(R]. Assets excess returns are normally distributed with a covariance matrix L:. the market capitalization is given by Mi.. views. The indistribution that is proporvestor can express views about tional to a product of two northe relative performance of assets mal distributions. . and those of similar experiments with other strategies.

"Asset Allocation: Combining Investor Views with Market Equilibrium" (Goldman. all at time t. F Black and R. We intend to address issues concerning uncertainty of the covariances in another paper. the excess return on a foreign currency. Op.4 for bonds and 5. "Capital Asset Prices:A Theory of Market Equilibrium Under Conditions of Risk. R. August 1974. We try here to develop the intuition behind our approach using some basic concepts of statistics and matrix algebra. September 1964 3. pp. "AnEquilibrium Model of the International Capital Market. 15. 7% risk here and throughout the article because it happens to be the risk of the market-capitalization-weighted 80% currency-hedgedportfolio that will be held in equilibrium in our model. September 1990). "UniversalHedging: How to Optimize Currency Risk and Reward in International Equity Portfolios. Exchange rates in this world are the rates of exchange between the different consumption bundles of individuals of diferent countries. The "universal hedging" equilibrium is. In this article we use the term "strength" a view to refer to its of magnitude."Journal of Economic Theory. H Theil.nomics and Statistics." Journal of Finance. H. where F't+' is the one-periodforward exchange rate at time t. Principles of Econometrics (New York:Wiley and Sons. Black. as follows-. 11. See Black.2 currencies. all excess returns and volatilities are percentages. P') indicates a transposed vector or matrix. 10. - z -J z U z L4 43 . Grauer. 12. R.February 1965. 1971). "UniversalHedging. or F. The return on a forward contract or. 4 In actual applications of the model." Journal of Financial Economics 3 (1976). 6 We choose to normalize on 10. cit 9. A more formal mathematical description is given in the appendix. For the purposes of this exercise. E Stehle. 16 For details of these views. We define excess return on currency-hedged assets to be total return less the short rate and excess return on currency positions to be total return less theforward premium. In Table II. we could easily apply the basic idea of this article-combining a global equilibrium witb investors' views-to another global equilibrium derivedfrom a different. Sachs & Co. see the following Goldman Sachs publications: The International Fixed Income Analyst August 2. The currency-hedged excess return on a bond or equity at time t is given by: Pt + l/Xt + 1 Pt/xt - Et = * 100 (1 + Rt)FXt-Rt. we treat the true covariances of excess returns as known. 233-56) While these simplifying assumptions are necessary to justify the universal hedging equilibrium. Solnik. Views can representfeelings about the relationships between observable conditions and such relative values. for interest rates and The International Economics Analyst. 18. L. for exchange rates. 0. this equilibrium does have the virtue of being simpler than other global CAPM equilibriums that have been described elsewhere.. we typically include more asset classes and use daily data to measure more accurately the current state of the time-varying risk structure. equivalently. A. Litterman.1 for equities. We discuss this situation later." op. Xt the exchange rate in units offoreign currency per US dollar.. of course. where P. 7. F Black." Financial AnalystsJoumaL July/August 1989." Cit a) 0) ui U 0 co : LLJ LX z 0 L/. "Universal Hedging. 5. and W F Sbarpe. the domestic short rate and FX. For the purposes of this article. such as a world with no taxes.set of assumptions. no capital constraints and no inflation. (See B. 13. H Litzenbergerand R. is the price of the asset in foreign currency. based on a set of simplifying assumptions. 8.g. July/August 1991. 17. 14. While some may find the assumptions that justify universal hedging overly restrictive. we arbitrarily assigned to each country the average historical excess return for across countries. "SharingRules and Equilibrium in an International Capital Market Under Uncertainty. 1991. less restrictive. We reservethe term "confidence"to refer to the degree of certainty with which a view is held. A 'prime" symbol (e. the return on a forward contract. is given by: Ftt +1 t1 1 FXt= xt ' 100.

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