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Asset Management

Asset Management. Lecture 7. Outline for today. Adjustments with the precision of alpha Organization chart of the portfolio management The Black-Litterman Model. Adjusting Forecasts for the Precision of Alpha . Absent of analysis, the prior of alpha = 0

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Asset Management

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  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

  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(RB) and E(RS) can be inferred Similarly, E(RS) 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)

  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:

  14. The Black-Litterman Model Step 4: Developing revised (posterior) expectations Baseline view:

  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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