Lecture 8 Flashcards
What is the Treynor & Black portfolio optimization model?
Key concepts:
Market Portfolio (Passive Component):
Assumes that the market portfolio is efficient, as per the Capital Asset Pricing Model (CAPM). Represents the benchmark or base portfolio that captures systematic risk.
Active Portfolio:
Consists of a selection of securities that are believed to be mispriced based on forecasts of their expected returns.
The securities in the active portfolio are weighted based on their alphas (excess returns above the market) and idiosyncratic risk (specific risk not related to the market). Blending Passive and Active Portfolios:
The optimized portfolio combines the market portfolio with the active portfolio to create a portfolio that maximizes the Sharpe ratio (risk-adjusted returns).
What are the steps in the Treynor-Black model?
- Identify mispriced securities for the active portfolio by calculating alpha.
Final portfolio return is:
Rp = Wa * Ra + (1-Wa)Rm
What is the Treynor Measure?
Please explain this diagram
Top left:
This displays the Treynor measure which is the best ratio for evaluating individual managers of a fund against each other. This is because Treynor measures only excess return per unit of systematic risk. In an already well-diversified portfolio, idiosyncratic risk is minimized, leavind only systematic risk to evaluate.
Between top left and top right:
Sharpe ratio is best. This is because it assesses the overall risky portfolio/investment fund. Here we wish to evaluate which of the two funds is doing best relative to total risk. (Excess return per unit of risk)
Bottom:
We are combining an actively managed portfolio with a market portfolio. Here Information ratio is best. This is because the information ratio focuses on the manager’s stock selection skills, which is measured by Alpha relative to the active portfolio’s idiosyncratic risk. (How much extra return (alpha) the active manager generates for each unit of idiosyncratic risk)
