The Black-Litterman Model Explained.

Active portfolio management

Mean variance optimization has a few problems. For example,
in Markowitzs paradigm optimal portfolios are highly
concentrated and very sensitive to provided inputs. Empirical
evidence also indicates that small change in expected returns
can cause a drastic change in portfolio composition. So we get
some wired portfolios sometimes.
The Black-Litterman model is represented as an asset
allocation model but is essentially a model to forecast
expected returns and once we know expected returns we can
use standard optimization techniques to arrive at the optimal
portfolio. What BL do is what we can call reversed
optimization in order to arrive to an estimate of implied
equilibrium excess returns. It also allows us to incorporate our
views about various stocks or assets that comprise our
portfolio and also our confidence about our views to generate
the expected returns vector.
First, let us consider the notion of implied equilibrium excess
returns. Let us start by writing the investors utility function:
U= wR 0.5ww (1)
So, U stands for utility. The utility function is equal to the
expected return which is w transposed times the return. Now,
the risk is going to be penalized by subtracting from our
expected returns half times the risk aversion parameter or the
price of risk (denoted by lambda here), times w transposed
1

times the variance-covariance matrix () times w. This last

term captures the variance of the portfolio.

We want to maximize the utility function subject to the

constraint that the sum of the weights always should be equal
to one.
U= wR 0.5ww,

s.t. w1=1

(2)

To maximize this function we are going to take a partial

derivative of U with respect to w which is going to give us
from the first term R and from the second term we are going
to get one half times 2 because w transposed times w is
equivalent to writing w square, so 2 times the risk aversion
parameter times the variance covariance matrix times w. The
two twos are going to cancel out. Thus we are going to have R
minus the risk aversion parameter times the variance
covariance matrix times w.
U
w =R-

1
2 .2w=R- w

(3)

In order to maximize the utility, we set the derivative equal to

zero.
U
w =R-

1
2 .2w=R- w=0

(4)

Now, what Black-Litterman did was rather than solving for

optimal weights, they argued that weights are already
observed in the market and therefore we can compute them
using market capitalization. What they did for that was to
reverse the problem. This solves for R from equation (4). So
we are going to see is that R is simply equal to the risk
aversion parameter times the variance covariance matrix
times the market weights.
2

R= w

(5)

The risk aversion parameter or the price of risk can also be

written as the excess return on the market divided by the
variance of the market.
=

E ( r m ) r f
2m

(6)

Now, we are in agreement with the excess returns thus

generated we should hold the market portfolio because in the
absence of any other view these returns takes back to the
market weights. Let us call this implied equilibrium excess
returns as a vector and let us call .
Now, let us introduce views about the stocks or the assets
that comprise the portfolio. We can have absolute views. For
example, the return on Googles stock will be 2% in the near
future. We can also have relative views, for example, the
return on Googles stock will be greater than the return on
Apples stock by 1%. In practice, relative views are more
common.
Let us consider a three asset portfolio. We believe that the
return in asset A is going to exceed the return on asset B by
1%:
rA

>

rB

by 1%

We can also say; the return on asset C is going to exceed the

return on asset A by 0.5%:
rC

>

rA

by 0.5%

So we have two views, which can be expressed as a vector.

Let us see how this vector looks like. Let us name this vector
Q and call it views vector. And we can write this vector as
3

[ ]

0.01
simply as Q= 0.005 . In this case a 2X1 vector. In general

terms, Q will be an NX1 vector, where N would be the number

of views.
The problem is that by looking at vector Q, we do not what the
views are about. So what we need to have is a matrix which is
going to establish a link between our views and what the
views are about. Let us call this matrix, matrix P. In this matrix
P, each row represents a view. So we have two views. We also
have three assets that are going to be written in columns.
A

[ ]

The question now is what is going to be the elements of this

matrix. For each positive view we can write a one, and for
each negative view we can write a -1, but do keep in mind
that the sum of relative views should be zero. What are our
views? We believe that the return on asset A is going to be
greater than the return on asset B, so we are positive about
asset A. So, in the row one, the first view, and we are negative
about asset B so we can write a minus one below B. The first
view does not talk about asset C at all, so we can write a zero
below C. The sum of these views is going to be zero. Likewise
we can fill the row for the second view. We are positive about
C and relative speaking negative about asset A. Second view
does not talk anything about asset B.
A

B
1

P= 1

1 0
0 1

(7)

Let us now focus on risk. It is pretty obvious that regarding

expected returns there will be some uncertainty about them. If
we want to have a measure of confidence about expected
implied equilibrium returns, we can express this confidence by
simply writing variance covariance matrix inverse. Because
the variance covariance matrix represents uncertainty and the
inverse is going to represent the confidence that we wave
about estimated implied equilibrium excess returns. Likewise,
the views that we have are just views or opinions, they are not
facts. They are not set in stone. Therefore, there is an
uncertainty about the views also. So if views are represented
by vector Q, there is also going to be a vector for the error
term. Let us write down this as follows. Because we are not
100% sure about views, there is going to be an error
component:

[ ] [ ] [ ] [ ] (8)

Q+ =

Q1 1

+ = 0.01 + 1
0.005 2
Q2 2

We are going to assume that the errors terms are normally

distributed, which we can write them as follows:

[ ] [( ) (

1
0 11 12
N
,
0 21 22
2

)] (9)

The uncertainty about our views has a zero mean and some
variance. The uncertainty matrix which in this case is a 2X2
matrix we will call it omega,

There is not one way to compute the elements of omega

matrix. Black Litterman suggest that the elements can be
calculated as a scalar

( )

times the link matrix times the

variance covariance matrix times the transposed of the link

matrix.
5

=P P'

(10)

Tau is just a scalar and it is just as abstract as omega. BlackLitterman has used the value of 0.025 in their paper. Other
people or researchers have used the value of one. For the
sake of convenience, let us use 1 for tau. In any case, if
omega represents the uncertainty and we want to have a
measure of confidence about our views, we simply write the
measure of confidence about our views as the inverse of the
omega.
1
Confidence on views:

We have introduced a lot of concepts. Let us collect of all

them in one place. The list of inputs for our three assets
portfolio is the following:
=scalar ( 1 )
=3 x 1 vector

(Implied equilibrium excess returns)

=3 x 3

(variance covariance matrix)

Q=2 x 1 vector

P=2 x 3
=2 x 2

(Views)

(Link matrix)

(Uncertainty about views)

What Black Litterman formula does is to give us an estimate

of excess returns by calculating a weighted average of two
items. What are those two items? A weighted average of
implied equilibrium excess returns,

, and our views

captured by a Q vector. We will have a weighted average of

these two items. The question is what the weights are. The
6

first weight is the confidence about

And it is represented

by the scalar times the variance covariance matrix and

because we are measuring the confidence we take the
inverse.
1. ( )

The second weight is going to be related about our views. How

confident are we about our views. The confidence is to be
represented by the omega inverse and we said that just by
looking at the vector Q we would have it an idea of what the
views are about. So, we will have a link matrix P transposed
times the uncertainty matrix.
1

2. P '

What we have is just a weighted average of about implied

equilibrium returns and views.
( )1 + P ' 1 Q (12)
Weighted
equilibriu
m returns

Weighte
d Views

The last term is actually the second term in the B-L formula.
We know that the sum of the weights should be equal to one.
This is assured by multiplying the last term by the first term in
the B-L formula:
1

[ ( )1+ P ' 1 P ]

(13)

Let us conclude by writing the complete B-L formula. What we

have is that the excess returns are simply equal to the first
term multiplied by the second term.
1

E ( r m ) r f =[ ( )1+ P ' 1 P ] [ ( )1 + P ' 1 Q ]

(14)

Weighted average of
equilibrium returns and
views

Making sure the sum of

weights will be equal to
one