Sample Question #198 (finance – portfolio optimization)

What’s the Black-Litterman model for portfolio optimization? What’s its significance?

(Comment: this model is very important in the portfolio management industry; the second part of this question probes your understanding of why it’s important)

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ANSWER

In the mean-variance portfolio optimization framework, the central question is, how does one forecast all the needed input variables, the expected security returns and the expected covariance matrix?

The Black-Litterman model takes a "short cut" to the problem of coming up with expected returns. It assumes that the market equilibrium portfolio (i.e., the "market portfolio") is efficient, hence it encapsulates an optimal portfolio of all securities. Then, one can back-track the calculations and, incorporating one’s view of future market returns into a given covariance matrix, derive the market-efficient expected returns of individual securities. It’s like using an option’s implied volatility as the future expected volatility of the underlying asset. One can also add further one’s own views about some of the security returns. The idea is, instead of trying to forecast thousands of returns, one can use the market porfolio to reduce the number of forecasts significantly. This short cut makes it possible to use the mean-variance paradigm in the real world, as long as one accepts the market portfolio as the best forecaster in the world.