You want to use the Black-Litterman model to decide on your investment allocation across US equity...

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You want to use the Black-Litterman model to decide on your investment allocation across US equity sectors, for which the current market capitalisation (in US$ trillion) is shown in Table 4 below. Sector Communication Services Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Real Estate Utilities Table 4 Total Market Cap 3.79 6.18 4.16 3.79 7.42 7.41 4.81 11.27 2.10 1.31 1.54 53.78 You also have historical data for the returns of the sector indices. Now, suppose you have uncertainty regarding the market-implied estimate of these sector ex- pected excess returns, so that your beliefs for expected excess returns (denoted by the vector μ) are captured by the following specification: μ = II + €M where the vector EM is normally distributed with mean 0 and variance-covariance matrix TE. How does the introduction of these prior beliefs affect your optimal portfolio weights in these sector indices and the risk-free asset? Show your calculation and explain the intuition. Suppose is increased, how would your investment in the risk-free asset change? Explain. You want to use the Black-Litterman model to decide on your investment allocation across US equity sectors, for which the current market capitalisation (in US$ trillion) is shown in Table 4 below. Sector Communication Services Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Real Estate Utilities Table 4 Total Market Cap 3.79 6.18 4.16 3.79 7.42 7.41 4.81 11.27 2.10 1.31 1.54 53.78 You also have historical data for the returns of the sector indices. Now, suppose you have uncertainty regarding the market-implied estimate of these sector ex- pected excess returns, so that your beliefs for expected excess returns (denoted by the vector μ) are captured by the following specification: μ = II + €M where the vector EM is normally distributed with mean 0 and variance-covariance matrix TE. How does the introduction of these prior beliefs affect your optimal portfolio weights in these sector indices and the risk-free asset? Show your calculation and explain the intuition. Suppose is increased, how would your investment in the risk-free asset change? Explain.

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The BlackLitterman model combines the marketimplied expected returns captured by the market capitalization weights with the investors own views on the expected returns to determine optimal portfolio w... View the full answer