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FRM Part II · FRM Exam Part II · Portfolio Construction

A portfolio manager uses the Black-Litterman model to build a global equity allocation. In this framework, what is the starting point (prior) for the expected returns before any investor views are incorporated?

The prior is the set of equilibrium implied returns found by reverse optimizing from market capitalization weights. This makes the market portfolio optimal when the investor has no views, and views then tilt the returns away from equilibrium in a Bayesian way.

  1. AHistorical average returns for each asset over the past decade
  2. BEquilibrium implied returns obtained by reverse optimization from market capitalization weightsCorrect
  3. CZero excess returns for all assets
  4. DThe manager's most confident view on each asset

Explanation

Black-Litterman begins with equilibrium returns implied by market-cap weights through reverse optimization, so that the market portfolio is optimal absent views. Historical averages are noisy and produce extreme weights, which the model is designed to avoid. Views are layered on afterward.

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