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Introduction
In Finance the TreynorBlack model is a
mathematical model for security selection
published by Fischer Black and Jack Treynor in
1973.
The model assumes an investor who considers
that most securities are priced efficiently, but
who believes he has information that can be used
to predict the abnormal performance (Alpha) of a
few of them;
the model finds the optimum portfolio to hold
under such conditions.
Treynor-Black Model
Model used to combine actively managed
stocks with a passively managed portfolio.
Using a reward-to-risk measure that is similar
to the the Sharpe Measure, the optimal
combination of active and passive portfolios
can be determined.
In essence the optimal portfolio consists of two
parts:
(i) a passively invested index fund containing all
securities in proportion to their market value
and
(ii) an 'active portfolio' containing the securities for
which the investor has made a prediction about
alpha.
In the active portfolio the weight of each stock is
proportional to the alpha value divided by the
variance of the residual risk.
Treynor-Black Model: Assumptions
Passive Portfolio :
2
r m r f
2
R
M
2
S
M
M
2 2
M
Reward to Variability Measures
Appraisal Ratio:
2
A
e) A
(
Reward to Variability Measures
Combined Portfolio :
2
R
2
S 2
M A
2
M (e) A
P
Treynor-Black Model
The Treynor-Black model assumes that the
security markets are almost efficient
Active portfolio management is to select the
mispriced securities which are then added to the
passive market portfolio whose means and
variances are estimated by the investment
management firm unit
Only a subset of securities are analyzed in the
active portfolio
Steps of Active Portfolio Management
1) Estimate the alpha, beta and residual risk of each
analyzed security. (This can be done via the
regression analysis.)
2) Determine the expected return and abnormal return
(i.e., alpha)
3) Determine the optimal weights of the active portfolio
according to the estimated alpha, beta and residual
risk of each security
4) Determine the optimal weights of the the entire
risky portfolio (active portfolio + passive market
portfolio)
Advantages of TB model
p . A
CML
Risk
rA=aA + rf +bA(rm-rf)
Given:
rp = wrA + (1-w)rm
wk = ak/s2(ek)
a1/s2(e1)+...+an/s2(en)
rp = wrA + (1-w)rm