The Black-Litterman Model: Applied to Strategy Combination

Publisher: Lehman Brothers

Abstract:

As explained in Cheung (2007a & b), the Black-Litterman (BL) Model (Black and Litterman, 1992) represents an elegant framework for view blending; and thus a natural technique for strategy combination. If PM just wants to mix views on strategies, and does not mind allocation to individual assets, the BL model suffices in its original form or its augmented form (Cheung, 2007c).

However, if the PM wants to allocate at the strategy level, the model does not immediately lend itself to easy practice. This potentially frustrates application.

In this article, we demonstrate that by choosing a proper prior, the BL model can be used for such purpose. Also, we devote a part of this article to an analysis of a simple 2-strategy combination problem. Taking the advantage of the simplicity, a comparison of the BL-based optimisation and the traditional optimisation is given as well.

Source: Manual