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# Treynor Black Model

RAVI IBA
Introduction
In Finance the TreynorBlack model is a
mathematical model for security selection
1973.
The model assumes an investor who considers
that most securities are priced efficiently, but
who believes he has information that can be used
to predict the abnormal performance (Alpha) of a
few of them;
the model finds the optimum portfolio to hold
under such conditions.
Treynor-Black Model
Model used to combine actively managed
stocks with a passively managed portfolio.
Using a reward-to-risk measure that is similar
to the the Sharpe Measure, the optimal
combination of active and passive portfolios
can be determined.
In essence the optimal portfolio consists of two
parts:
(i) a passively invested index fund containing all
securities in proportion to their market value
and
(ii) an 'active portfolio' containing the securities for
alpha.
In the active portfolio the weight of each stock is
proportional to the alpha value divided by the
variance of the residual risk.
Treynor-Black Model: Assumptions

## Analysts will have a limited ability to find a select

number of undervalued securities.
Portfolio managers can estimate the expected
return and risk, and the abnormal performance
for the actively-managed portfolio.
Portfolio managers can estimate the expected
risk and return parameters for a broad market
(passively managed) portfolio.
Reward to Variability Measures

Passive Portfolio :
2

r m r f
2
R

M

2
S
M
M
2 2

M

Reward to Variability Measures

Appraisal Ratio:
2
A

e) A
(
Reward to Variability Measures

Combined Portfolio :
2
R
2

S 2
M A

2

M (e) A
P
Treynor-Black Model
The Treynor-Black model assumes that the
security markets are almost efficient
Active portfolio management is to select the
mispriced securities which are then added to the
passive market portfolio whose means and
variances are estimated by the investment
management firm unit
Only a subset of securities are analyzed in the
active portfolio
Steps of Active Portfolio Management
1) Estimate the alpha, beta and residual risk of each
analyzed security. (This can be done via the
regression analysis.)
2) Determine the expected return and abnormal return
(i.e., alpha)
3) Determine the optimal weights of the active portfolio
according to the estimated alpha, beta and residual
risk of each security
4) Determine the optimal weights of the the entire
risky portfolio (active portfolio + passive market
portfolio)

## TB analysis can add value to portfolio

management by selecting the mispriced assets
TB model is easy to implement
TB model is useful in decentralized
organizations
TB Portfolio Selection
For each analyzed security, k, its rate of return can
be written as:
rk -rf = ak + bk(rm-rf) + ek
ak = extra expected return (abnormal
return)
bk = beta
ek = residual risk and its variance
can be estimated as s2(ek)
Group all securities with nonzero alpha into a
portfolio called active portfolio. In this portfolio,
aA, bA and s2(eA) are to be estimated.
Combining Active Portfolio with
Market Portfolio (passive portfolio)
Return
New CAL

p . A
CML

Risk

rA=aA + rf +bA(rm-rf)
Given:
rp = wrA + (1-w)rm

## The optimal weight in the active portfolio is:

w = w0/[1+(1-bA)w0]
aA/s2(eA)
where w0=
(rm-rf)/s2m
The slope of the CAL (called the Sharpe index) for
the optimal portfolio (consisting of active and
passive portfolio) turns out to include two
components, which are: [(rm-rf)/sm]2 + [aA/s2(eA)]2
The optimal weights in the active
portfolio for each individual security
will be:

wk = ak/s2(ek)
a1/s2(e1)+...+an/s2(en)

## Weightings for securities in the actively managed portfolio:

wi = (alphai / (unsystematic riski))/(j=1n(alphaj / (unsystematic
riskj)))
Illustration of TB Model
Stock a b s(e)
1 7% 1.6 45%
2 -5 1.0 32
3 3 0.5 26
rm-rf =0.08; sm=0.2
Let us construct the optimal active portfolio implied by
the TB model as:
Stock a/s2(e) Weight (wk)
1 0.07/0.452 = 0.3457 (1)/T = 1.1417
2 -0.05/0.322 = -0.4883 (2)/T = -1.6212
3 0.03/0.262 = 0.4438 (3)/T = 1.4735
Total (T) 0.3012
Composition of active portfolio:
aA = w1a1+w2a2+w3a3
=1.1477(7%)-1.6212(5%)+1.4735(3%)
=20.56%
bA = w1b1+w2b2+w3b3
= 1.1477(1.6)-1.6212(1)+1.4735(0.5)
= 0.9519
s(eA) = [w21s21+w22s22+w23s23]0.5
= [1.14772(0.452)+1.62122(0.322) +1.47352(0.262)]0.5
= 0.8262
Composition of the optimal portfolio:
w0 = (0.2056/0.82622) / (0.08/0.22)
= 0.1506
w k = w0 /[1+(1-bA) w0 ]
= 0.1495
Composition of the optimal portfolio:

## Stock Final Position

w (wk)
1 0.1495(1.1477)=0.1716
2 0.1495(-1.6212)=-0.2424
3 0.1495(1.1435)=0.2202
Active portfolio 0.1495
Passive portfolio 0.8505
1.0

rp = wrA + (1-w)rm