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Variance
j
µ ¶ µ ¶
¾ 12 ¾ 12 w1
¾ p2 := V a r [r p ] = w 0 V w = (w 1 w 2 )
¾ 21 ¾ 22 w2
µ ¶
w1
= (w 1 ¾ 12 + w 2 ¾ 2 1 w 1 ¾ 1 2 + w 2 ¾ 22 )
w2
= w 12 ¾ 12 + w 22 ¾ 22 + 2 w 1 w 2 ¾ 1 2 ¸ 0
s in ce ¾ 1 2 · ¡ ¾ 1 ¾ 2 : recall that correlation
coefficient 2 [-1,1]
ILLUSTRATION OF 2 ASSET CASE
¹p = ¹1 + ¹¾22¡¹
¡¾1 (§ ¾p ¡ ¾1 )
1
E[r2]
mp
E[r1]
s1 sp s2
¹2¡¹1
¹p = ¾ ¾+¾
2 ¹ +
1
¾1
¾1+¾2 § ¾1+¾2 ¾p
1 2
E[r2]
¹2 ¡¹1
slop e: ¾1 + ¾2
¾p
¾2 ¾1
¹
¾ 1 +¾ 2 1
+ ¹
¾ 1 +¾ 2 2 ¹2 ¡¹1
slop e: ¡ ¾p
E[r1] ¾1 + ¾2
s1 s2
E[r2]
E[r1]
s1 s2
E[r2]
mp
E[r1]
s1 sp s2
The Efficient Frontier: One Risky and One Risk Free Asset
EFFICIENT FRONTIER WITH N RISKY ASSETS
1 T
min w Vw
w 2
s
s.t. w e E ~r ) E
T N
w E (
i 1
i i
N
w T1 1
i 1
w i 1
@L = V w ¡ ¸e ¡ °1 = 0
@w
@L = E ¡ wT e = 0
@¸
@L = 1 ¡ wT 1 = 0
@°
The first FOC can be written as:
V wp = ¸e + °1 or
¡1
wp = ¸V e + °V 1 ¡1
T T ¡1 T ¡1
e wp = ¸(e V e) + °(e V 1)
Noting that eT wp = wTpe, using the first foc, the second foc
can be written as
CE¡A
¸ = D and ° = D B¡AE
where D = BC ¡ A2.
Hence, wp = V-1e + V-11 becomes
CE A 1 B AE 1
wp V e V 1
D (vector) D (vector)
scalar) scalar)
1
D
1
D
BV 11 AV 1e CV 1e AV 11 E
(6.15)
wp g h E
linear in expected return E!
(vector) (vector) (scalar)
If E = 0, wp = g
Hence, g and g+h are portfolios
If E = 1, wp = g + h
on the frontier.
EFFICIENT FRONTIER WITH RISK-FREE ASSET
minw 12 w TV w
FOC: wp = ¸V ¡1(e ¡ rf 1)
E[rp]¡rf
Multiplying by (e–rf 1)T and solving for yields ¸ =
(e¡rf 1)T V ¡1(e¡rf 1)
¡1 E[rp ]¡rf
wp = V (e ¡ rf 1) H2
| {z }
n£1
q
where H = B ¡ 2Arf + Crf2 is a number
EFFICIENT FRONTIER WITH RISK-FREE ASSET
Result 1: Excess return in frontier excess return
Cov[rq ; rp ] = wqT V wp
E[rp ] ¡ rf
= wqT (e ¡ rf 1)
| {z } H2
E[rq ]¡rf
(E[rq ] ¡ rf )([E[rp ] ¡ rf )
=
H2
(E[rp ] ¡ rf )2
V ar[rp ; rp ] =
H2
Cov[rq ; rp]
E[rq ] ¡ rf = (E[rp] ¡ rf )
V ar[rp]
| {z }
:=¯q;p
Holds for any frontier portfolio p, in particular the market portfolio!
EFFICIENT FRONTIER WITH RISK-FREE ASSET
(E[rp ] ¡ rf )2
V ar[rp ; rp ] =
H2
E[rp ] = rf + H¾p
E[rp ]¡rf
H= ¾p
where H is the Sharpe ratio
TWO FUND SEPARATION
Advantage:
Same portfolio of n risky asset for different agents
with different risk aversion
Useful for applying equilibrium argument (later)
TWO FUND SEPARATION
Price of Risk =
= highest
Sharpe ratio
Example: E[W ] ¡ °
2V ar[W ]
Also in expected utility framework
quadratic utility function (with portfolio return R)
U(R) = a + b R + c R2
vNM: E[U(R)] = a + b E[R] + c E[R2]
= a + b mp + c mp2 + c sp2
= g(mp, sp)
E[ RM ] R f
E[ R p ] R f sp
sM
CAPITAL MARKET LINE
CML
M
rM
rf
j
sM sp
SECURITY MARKET LINE
E(r)
SML
E(ri)
E(rM)
rf
slope SML = (E(ri)-rf) /b i
b M 1 bi b
Cov[rj ; rM ]
E[rj ] = ¹j = rf + (E[rM ] ¡ rf )
V ar[rM ]
| {z }
¯j
OVERVIEW
. s2 t2
E ( | x) 2 m 2
2
x
2
t s t s
BLACK LITTERMAN PRIOR
Investor’s views
P ¹ = Q + "v , where "v » N(0; -)
is a off-diagonal values are all zero
"v and "0are all orthogonal
BAYESIAN POSTERIOR - REWRITTEN
s2 t2
E ( | x) 2 m 2
2
x
2
t s t s
1t2 1s2
2 m 2
2
x
2
1 t 1 s 1 t 1 s
1
1 t 1 s
2 2
1
t 2
m 1 s 2
x
BAYESIAN UPDATING
Black Litterman updates returns to reflect views using
Bayes’ Rule.
The updating formula is just the multi-variate (matrix)
version of
E ( | x)
1
1 t 1 s
2 2
2
1 t m 1 s x
2
E[ R | Q] t P P
1 T 1
t
1 1
PT 1Q
BAYESIAN UPDATING
E ( | x)
1
1 t 1 s
2 2
2 2
1 t m 1 s x
E[ R | Q] t P P
1 T 1
t
1 1
P Q
T 1
Scaling term – Total precision
BAYESIAN UPDATING
E ( | x)
1
1 t 1 s
2 2
1 t m 1 s x
2 2
E[ R | Q] t P P
1 T 1
t
1 1
P Q T 1
CAPM Prior
expected returns
BAYESIAN UPDATING IN BLACK
LITTERMAN
E ( | x)
1
1 t 1 s
2 2
1 t m 1 s x
2 2
E[ R | Q] t P P
1 T 1
t
1 1
P Q
T 1
Weighted by
precision of
CAPM Prior
BAYESIAN UPDATING
E ( | x)
1
1 t 1 s
2 2
1 t m 1 s x
2 2
E[ R | Q] t P P
1 T 1
t
1 1
P QT 1
Vector of expected
return views
BAYESIAN UPDATING
E ( | x)
1
1 t 1 s
2 2
1 t m 1 s x
2 2
E[ R | Q] t P P
1 T 1
t
1 1
P QT 1
Weighted by
precision of views
ADVANTAGES OF BLACK-LITTERMAN