Black-Litterman

A Bayesian equilibrium expected return model

Black-Litterman returns combine the market equilibrium return expectation (CAPM) with the investor’s unique market views. An investor’s views for a given asset can be either absolute or relative to another asset. The Black-Litterman model is designed as a means of constructing a sensible set of expected returns that is consistent with the equilibrium framework.

This methodology uses equilibrium returns and the covariance of the selected risk estimation method as a starting point. Next, the software uses the given confidence level to estimate a covariance for the user-specified views.

The equilibrium distribution and the information inferred from investors’ views are used as inputs in the Black-Litterman framework, from which the combined return distribution is then derived.