Skip to content

FRM Part II · FRM Exam Part II · Portfolio Construction

In a Black-Litterman application, an analyst expresses the view that Asset A will outperform Asset B by 2%, and sets the view uncertainty (omega) very high relative to the prior covariance of returns. What is the most likely effect on the posterior expected returns and optimal weights?

Posterior returns stay close to equilibrium and weights close to market weights. A very high view uncertainty means low confidence, so the Bayesian blend gives the view little weight relative to the prior, and only a small tilt toward Asset A over Asset B results.

  1. APosterior returns move almost fully to the view, producing large active positions
  2. BPosterior returns stay close to the equilibrium returns, so weights stay close to market weightsCorrect
  3. CPosterior returns become zero for both assets
  4. DThe model rejects the view and cannot be solved

Explanation

High omega means low confidence in the view, so the Bayesian weighting gives the view little influence relative to the prior. Posterior returns remain near equilibrium and weights near market weights. Low omega would produce the opposite, a strong tilt toward the view.

Did you get it right without looking?

One question tells you little. A timed set on Portfolio Construction shows your real accuracy, how long you take and where you lose marks.

Practise Portfolio ConstructionFree diagnostic mock

More Portfolio Construction questions