Understanding the Treynor-Black Model

The Treynor-Black model was published in 1973 by economists Jack Treynor and
Fischer Black. Treynor and Black assumed that the market is highly but not
perfectly efficient. Following their model, an investor who largely agrees with the
market pricing of an asset may also believe that they have additional information that
can be used to generate excess returns—known as alpha—from a select few
mispriced securities.

The investor using the Treynor-Black model will thus select a small mix of
underpriced securities to create a dual-partitioned portfolio, based on their own
research and insight. One portion of the portfolio follows a passive index investment,
and the other part an active investment in those mispriced securities.

The Treynor-Black model provides an efficient way of implementing an active

investment strategy. Because it is hard to always pick stocks accurately as the model
requires, and since restrictions on short selling may limit the ability to exploit market
efficiencies and generate alpha, the model has gained little traction with investment
managers or investors.

What Is the Treynor-Black Model?

The Treynor-Black model is a portfolio optimization model that seeks to maximize a
portfolio's Sharpe ratio by combining an actively managed portfolio built with a few mispriced
securities and a passively managed market index fund. The Sharpe ratio evaluates the relative
risk-adjusted performance of a portfolio or a single investment against the risk-free rate of
return, such as the yield on U.S. Treasury securities.

What Is the Sharpe Ratio?

The Sharpe ratio compares the return of an investment with its risk. It's a
mathematical expression of the insight that excess returns over a period of time may
signify more volatility and risk, rather than investing skill.

The Sharpe Ratio Formula offers a simple method to help investors make these
calculations. The formula looks like this:

(Average Returns of an Investment - Returns of a Risk-free Investment) / Standard

Deviation
 Technically, we can represent this as: Sharpe Ratio = (Rp−Rf) / σp

Where:

 Rp = Average Returns of the Investment/Portfolio that we are considering.

 Rf = Returns of a Risk-free Investment.
 Sp= Standard Deviation of the Portfolio/Investment

In understanding this formula, there’s a need to explain the terms involved. 

Meaning of Terms
 Average Returns of the Investment/Portfolio: This refers to the average
expected returns from the investment.
 Returns of a Risk-free Investment: The Risk-free Investment refers to an
investment that is (almost) completely devoid of risk. As seen in the formula
above, returns of a risk-free investment are typically subtracted from the
average returns of total investments. The purpose is to arrive at the net-
returns that the investment actually generated. 
The "risk-free investment" that is usually referenced is government treasuries,
because they normally are expected to be devoid of any risks at all.
 Standard Deviation: The Standard Deviation of an investment tells us the
amount by which the particular investment can go up or down, the volatility
of the investment. In essence, the Standard Deviation refers to the risk
involved with the investment.

Sharpe Ratio Example

Our desired investment is the stock of ABC Corp. The stock has returned an
average of 15% annually over the past five years.

The risk-free investment is the UK Treasury Bill which has an interest rate of
0.3%.

The standard deviation (volatility) of ABC is put at 20%.

The Sharpe Ratio calculation = (15% - 0.2%) / 20%= 0.73.

What Is the Risk-Free Rate of Return?

The risk-free rate of return is the theoretical rate of return of an investment with zero
risk. The risk-free rate represents the interest an investor would expect from an
absolutely risk-free investment over a specified period of time.

The so-called "real" risk-free rate can be calculated by subtracting the current
inflation rate from the yield of the Treasury bond matching your investment duration.

What is the Risk-Free Rate Formula?

A risk-free rate of return formula calculates the interest rate that investors expect
to earn on an investment that carries zero risks, especially default risk and
reinvestment risk, over some time. It is usually closer to the base rate of a Central
Bank and may differ for the different investors. It is the rate of interest offered on
sovereign or government bonds or the bank rate set by the country’s Central Bank.
These rates are the function of many factors like – Rate of Inflation formula, GDP
Growth rate, foreign exchange rate, economy, etc.

Risk Free Rate of Return Formula = (1+ Government Bond Rate)/ (1+Inflation
Rate)-1
 The various applications of the risk-free rate use the cash flows in real terms. Hence, the risk-free
rate must also be brought to the same real terms, which is inflation-adjusted for the economy.
Since the rate is mostly the long-term government bonds – they are adjusted to the rate of
inflation factor and provided for further use.

The calculation depends upon the time period in evaluation.

If the period is up to 1 year, one should use the most comparable government security, which is
the Treasury Bills
, or simply the T-Bills
If the period is between 1 year to 10 years, one should use a Treasure Note.

If the period is more than ten years, one can consider selecting Treasure Bond.

Risk Free Rate of Return Formula = (1+ Government Bond Rate)/ (1+Inflation
Rate)-1

Use the following data for the calculation of the risk-free rate of
return.

 10 Year Government Bond Rate: 3.25%

 Inflation Rate: 0.90%
The risk-free rate of return can be calculated using the above formula
as,

=(1+3.25%)/(1+0.90%)-1
Risk-free Rate of Return = 2.33%