Asset Management Lecture 7. Outline for today Adjustments with the precision of alpha Organization chart of the portfolio management The Black-Litterman.

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Presentation on theme: "Asset Management Lecture 7. Outline for today Adjustments with the precision of alpha Organization chart of the portfolio management The Black-Litterman."— Presentation transcript:

1 Asset Management Lecture 7

2 Outline for today Adjustments with the precision of alpha Organization chart of the portfolio management The Black-Litterman Model

3 Adjusting Forecasts for the Precision of Alpha Absent of analysis, the prior of alpha = 0 A “tight” prior implies a high degree of confidence. The manager has to form a posterior distribution of alpha for portfolio construction.

4 Adjusting Forecasts for the Precision of Alpha How accurate is your forecast: forecasting record of analyst The realized abnormal return of time T The precision of record, t<T is the paird time series of past records Adjust

5 Figure 27.4 Organizational Chart for Portfolio Management

6 The Black-Litterman Model The model This approach uses past data equilibrium input the private “views” of the portfolio manager

7 The Black-Litterman Model Step 1: Estimate the covariance matrix from historical data Step 2: Determine a baseline forecast Step 3: Integrating the manager’s private views Step 4: Developing revised (posterior) expectations Step 5: Apply portfolio optimization

8 The Black-Litterman Model Step 1: Estimate the covariance matrix from historical data The textbook example Bonds (B)Stocks (S) SD0.080.17 Corr0.3 Cov Bonds0.00640.00408 Stocks0.004080.0289

9 The Black-Litterman Model Step 2: Determine a baseline forecast Market is in equilibrium The market portfolio is efficient. The textbook example: W(B)=0.25 W(S)=0.75

10 The Black-Litterman Model Step 2: Determine a baseline forecast According to CAPM Assuming that the average risk aversion=3 E(R B ) and E(R S ) can be inferred Similarly, E(R S ) can be found as 6.81%.

11 The Black-Litterman Model Step 2: Determine a baseline forecast Covariance matrix: it is about the precision of the forecast, instead of the actual volatility A conventional rule-of-thumb: 10% of the realized SD (or, 1% of the realized var) Bonds (B)Stocks (S) Expected return0.01400.0681 Cov Bonds0.0000640.0000408 Stocks0.00004080.000289

12 The Black-Litterman Model Step 3: Integrating the manager’s private views The view: in the next month, bonds will outperform stocks by 0.5% The expression:

13 The Black-Litterman Model Step 4: Developing revised (posterior) expectations Baseline view: Bonds (B)Stocks (S) Expected return0.01400.0681 Cov Bonds0.0000640.0000408 Stocks0.00004080.000289

14 The Black-Litterman Model Step 4: Developing revised (posterior) expectations Baseline view: Bonds (B)Stocks (S) Expected return0.01400.0681 Cov Bonds0.0000640.0000408 Stocks0.00004080.000289

15 The Black-Litterman Model Step 4: Developing revised (posterior) expectations The difference D

16 The Black-Litterman Model Step 4: Developing revised (posterior) expectations BL Updating formulas Notice the difference has reduced to 2.60%

17 The Black-Litterman Model Step 5: Apply portfolio optimization Markowitz optimizor Maximize Sharpe Ratio

18 The Black-Litterman Model Step 1: Estimate the covariance matrix from historical data Step 2: Determine a baseline forecast Step 3: Integrating the manager’s private views Step 4: Developing revised (posterior) expectations Step 5: Apply portfolio optimization


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