FRM Part II · FRM Exam Part II · Portfolio Construction
In a Bayesian interpretation of the Black-Litterman model, which pairing correctly identifies the components?
The equilibrium return distribution is the prior, the investor views with their uncertainty act as the likelihood or new information, and the combination is the posterior distribution of expected returns that is then used in portfolio optimization.
- APrior: investor views; likelihood: equilibrium returns
- BPrior: equilibrium return distribution; likelihood: investor views with uncertainty; posterior: combined expected return distributionCorrect
- CPrior: posterior covariance; likelihood: market weights
- DPrior: sample means; likelihood: risk-free rate
Explanation
The equilibrium returns with uncertainty (scaled by tau) form the prior. Views, with their error variance Omega, act as new information (likelihood). Combining them gives the posterior used in optimization. Option A reverses the roles.
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