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cn
Considerationof theglobal
CAPMequilibriumcan significantlyimprovethe usefulness of thesemodels.In
particular,equilibriumreturnsfor equities,bonds
and currenciesprovide
neutral startingpointsfor
estimatingthe set of expected excessreturns
needed to drive theportfolio optimizationprocess.
Thisset of neutral weights
can then be tilted in accordance with the investor's
views.
LU
LU
LU
z
D
-J
z
U
z
Z
28
Glossary
*"AssetExcess Returns:
*'Risk Premiums:
Means implied by the equilibrium model.
loBalance:
*Bencbmark Portfolio:
The standard used to define
the risk of other portfolios. If
a benchmark is defined, the
risk of a portfolio is measured
as the volatility of the tracking
error-the difference between
the portfolio's rerturns and
those of the benchmark.
*Equilibrium:
The condition in which means
(see below) equilibrate the
demand for assets with the
outstanding supply.
loEquilibrium Portfolio:
*Means:
Expected excess returns.
*Neutral Portfolio:
An optimal portfolio given
neutral views.
NoNeutral Views:
Means when the investor has
no views.
*Normal Portfolio:
The portfolio that an investor
feels comfortable with when
he has no views. He can use
the normal portfolio to infer a
benchmark when no explicit
benchmark exists.
uJ
La
Neutral Views
u
z
France
Japan
UK
US.
Canada
Australia
Currencies
Bonds
Equities
-20.8
15.3
112.9
12.6
-22.8
16.7
3.0
-13.1
107.8
Currencies
Bonds
Equities
-1.4
0.9
4.7
0.7
-1.5
0.9
0.2
-0.8
4.5
LL
France
Bonds
Currency
Equities
Bonds
Japan
Currency
Equities
Bonds
Currency
Germany
Equities
Bonds
Currency
1.00
0.28
0.02
1.00
0.36
1.00
France
Equities
Bonds
Currency
0.52
0.23
0.03
0.17
0.46
0.33
0.03
0.15
0.92
1.00
0.36
0.08
1.00
0.15
1.00
Japan
Equities
Bonds
Currency
0.37
0.10
0.01
0.15
0.48
0.21
0.05
0.27
0.62
0.42
0.11
0.10
0.23
0.31
0.19
0.04
0.21
0.62
1.00
0.35
0.18
1.00
0.45
1.00
UK
Equities
Bonds
Currency
0.42
0.14
0.02
0.20
0.36
0.22
-0.01
0.09
0.66
0.50
0.20
0.05
0.21
0.31
0.05
0.04
0.09
0.66
0.37
0.20
0.06
0.09
0.33
0.24
0.04
0.19
0.54
Equities
Bonds
0.43
0.17
0.23
0.50
0.03
0.26
0.52
0.10
0.21
0.33
0.06
0.22
0.41
0.11
0.12
0.28
-0.02
0.18
Canada
Equities
Bonds
Currency
0.33
0.13
0.05
0.16
0.49
0.14
0.05
0.24
0.11
0.48
0.10
0.10
0.04
0.35
0.04
0.09
0.21
0.10
0.33
0.14
0.12
0.02
0.33
0.05
0.04
0.22
0.06
Australia
Equities
Bonds
Currency
0.34
0.24
-0.01
0.07
0.19
0.05
-0.00
0.09
0.25
0.39
0.04
0.07
0.07
0.16
-0.03
0.05
0.08
0.29
0.25
0.12
0.05
-0.02
0.16
0.10
0.12
0.09
0.27
Us
United States
United Kingdom
Bonds
Canada
Bonds
Australia
Equities
Bonds
1.00
0.47
0.06
1.00
0.27
1.00
Equities
Bonds
0.58
0.12
0.23
0.28
-0.02
0.18
1.00
0.32
1.00
Canada
Equities
Bonds
Currency
0.56
0.18
0.14
0.27
0.40
0.13
0.11
0.25
0.09
0.74
0.31
0.24
0.18
0.82
0.15
1.00
0.23
0.32
1.00
0.24
1.00
Australia
Equities
Bonds
Currency
0.50
0.17
0.06
0.20
0.17
0.05
0.15
0.09
0.27
0.48
0.24
0.07
-0.05
0.20
-0.00
0.61
0.21
0.19
0.02
0.18
0.04
0.18
0.13
0.28
UK
Equities
Bonds
Currency
Currency
Equities
Equities
Currency
Equities
Bonds
US.
an
LU
U
LU
1.00
0.37
0.27
1.00
0.20
LU
4:
-J
Table III Optimal Portfolios Based on Historical Average Approach The equilibrium degree of hedging-the "universalhedging conGermany France Japan UK
US. Canada Australia stant"-depends on three averages-the averageacross countries
Unconstrained
of the mean return on the market
Currency
-78.7
46.5
28.6
15.5
65.0
-5.2
portfolio of assets, the average
Exposure (%)
across countries of the volatility
Bonds (%)
30.4
-40.7
40.4 -1.4 54.5 -95.7
-52.5
of the world market portfolio,
Equities (%)
4.4
-4.4
44.0
-44.2
15.5
13.3
9.0
and the average across all pairs of
countries
of exchange rate volatilWith Constraints Against Shorting Assets
ity.
-160.0
Currency
18.0
115.2
23.7
77.8
-13.8
Exposure (%)
Bonds (%)
Equities (%)
7.6
0.0
0.0
0.0
88.8
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
ra
on
cx:
LL
0
:
LU
LU
F0)
LI,
z
ax:
D
0
z
-j
U
z
32
32
Currency
Exposure (%)
Bonds (%)
Equities (%)
Currency
Exposure (%)
Bonds (%)
Equities (%)
14.5
-11.6
21.4
Unconstrained
-12.6
-0.9
4.2
-4.8
-1.8
23.0
4.4
-10.8
-4.6
13.9
32.2
-18.7
-2.1
-18.9
9.6
-32.7
10.5
0.0
0.0
0.0
22.1
0.0 0.0
0.0 27.0
0.0
8.2
-2.0
0.0
7.3
5.6
UK
Unconstrained
11.3 -28.6 -20.3
US.
Canada Australia
-50.9
-4.9
15.6
20.1
-6.7
0.0
19.5
1.01
2.29
6.27
1.10
2.23
8.48
1.40
2.88
8.72
UK
0.91
3.28
10.27
US.
Canada
Australia
1.87
7.32
0.60
2.54
7.28
0.63
1.74
6.45
an equilibriumvaluefor currency
hedging of 80%. Table VI gives
the equilibrium risk premiums
for all assets, given this value of
the universalhedging constant.9
Bonds (%)
Equities (%)
0.0
2.6
0.0
5.3
0.0
28.3
0.0
13.6
35.7
0.0
0.0
13.1
Australia
0.3
0.3
1.1
r'i
0)
0a
oL
LU
m
LU
L1J
Australia
D
z
-1.9
0.7
6.0
-0.6
-J
z
z
0.0
1.5
33
Three-Asset Example
Let us first work through a very
7TA +
yAE[Z]+ E[vj.
-J
ith asset,
= Q.
Table X
-J
Currency
Exposure (%)
Bonds (%)
Equities (%)
Germany
1.4
France
1.1
Japan
7.4
UK
2.5
US.
Canada
0.8
Australia
0.3
3.6
3.3
2.4
2.9
7.5
29.5
2.3
10.3
67.0
3.3
1.7
2.0
0.3
1.4
z
z
35
Table XI
Economists' Views
France
Japan
UK
1.743
5.928
137.3
1.688
1.790
6.050
141.0
1.640
Germany
Currencies
July 31, 1991
Current Spot Rates
Three-Month Horizon
Expected Future Spot
Annualized Expected
Excess Returns
Interest Rates
July 31, 1991
Benchmark Bond Yields
Three-Month Horizon
Expected Future Yields
Annualized Expected
Excess Returns
-7.48
-4.61
-8.85
-6.16
8.7
9.3
6.6
10.2
8.8
9.5
6.5
10.1
-3.31
-5.31
1.78
1.66
gives the formula for the expected excess returns that combine views with equilibrium in
the general case.
(r
0)
LU
[9.13.0
19.0
3.0
3.0
11.0
6.0
2.0
6.0
2.0
14.0]
US
1.000
Canada
Australia
1.151
1.285
1.156
1.324
0.77
-8.14
8.2
9.9
11.0
8.4
10.1
10.8
-3.03
-3.48
5.68
Note that we can identify the impact of the common factor only if
0
3.0 1.1 2.0
we assume that we know the true
6.0 2.0 4.1
structure that generated the cova0~
riance matrix of returns. That is
true here, but it will not be true in
Assume also, for simplicity, that
the percentage equilibrium risk This time, more than half of the general. The computation of the
premiums are equal-for exam- volatilityof A is associated with its conditional mean, however, does
z
ple, [1, 1, 1]. There is a set of
VI
D
::
market capitalizations for which
-J
that is the case.
r-J
Table XII Optimal (Unconstrained) Portfolio Based on Economists'
Views
U
z
Now consider what happens
when the investor expects A to
Germany France Japan
UK
US Canada Australia
:
outperform B by 2%. In this ex68.8
-12.7
Currency
16.3
-35.2
29.7
-51.4
Z ample, virtuallyall of the volatility
Exposure (%)
z
of the assets is associated with Bonds (%)
34.5
-65.4
79.2
16.9
3.3
-22.7
108.3
movements in the common fac- Equities (%)
-2.2
6.6
3.6
0.6
0.7
5.2
0.5
36 tor, and the expected return of A
LU
m
LU
6.0
Suppose the equilibrium risk premiums are again given by [1, 1, 1].
Now assume the investor expects
that A will outperform B by 2%.
Table XIII Optimal Portfolio With Less Confidence in the Economists' Views
Germany
Currency
Exposure (%)
Bonds (%)
Equities (%)
-12.9
-3.9
0.8
France
Japan
UK
-3.5
-10.0
-6.9
-21.0
2.2
19.6
24.7
2.6
7.1
US.
7.3
26.6
Canada
Australia
-0.4
-17.9
-13.6
4.2
42.4
1.2
not depend on this special knowl- only the returnsto U.S.bonds and
edge, but only on the covariance U.S. equities, holding fixed all
other expected excess returns.
matrix of returns.
Finally, let's look at the case
where the investor has less confidence in his view. We might say
(E[RA]- E[RB])has a mean of 2
and a variance of 1, and the covariance matrix of returns is, as it
was originally:
Anotherdifferenceis thathere we
specify a differentialof means,
lettingthe equilibriumdetermine
the actuallevels of means;above
we had to specify the levels directly.
Seven-Country Example
a')
co
LU
ax
H
Now we will attempt to apply our
LU
view that bad news about the U.S.
z
economy will cause U.S. bonds to
outperform U.S. stocks to the actual data. The critical difference
between our approach here and Table XIV Optimal Portfolio With Less Confidence in Certain Views
z
our earlier experiment that generated Table VIII is that here we
US. Canada Australia -J
UK
Germany France Japan
say something about expected re-7.8
-4.8
-2.8
-6.2
-10.0
-0.4
Currency
turns on U.S. bonds versus U.S.
0L
Exposure (%)
equities and we allow all other Bonds (%)
-2.4
28.1
1.6 22.9
-10.3
-34.3
25.5
expected excess returns to adjust Equities (%)
6.0
0.1
7.0 26.3
1.3
2.3
25.9
accordingly. Before we adjusted
Germany
1.5
France
1.5
Japan
7.0
0.5
1.0
0.5
1.0
2.0
5.0
global equilibrium
portfo-
on
LU
Lii
cL/
H-
-J
0
z
38
We have specified higher confidence in our view of yield declines in the United Kingdom and
yield increases in France and Ger-
UK
3.0
US.
Canada
2.0
Australia
0.0
30.0
55.0
1.0
1.0
0.0
0.0
Germany
France
4.4
3.4
2.0
2.2
1.0
3.4
0.5
2.9
4.7
22.3
2.5
10.2
Japan
UK
US.
13.0
32.0
Canada
Australia
2.0
5.5
0.3
1.7
3.5
2.0
TableXVII Annualized Expected Excess Returns Implied by a views of the portfolio shown in
Table XVI,given that the benchGiven Portfolio
markis, alternatively,(1) a marportUS.
UK
Canada Australia ket-capitalization-weighted
Germany France Japan
folio, 80% hedged, or (2) the
Views Relative to the Market-Capitalization Benchmark
domestic-weighted alternative
2.45
1.22
0.63
1.82
-0.27
1.55
Currencies
shown in TableXV.Unlessa port1.22
-0.01
1.03 -0.13
-0.58
0.30
-0.30
Bonds
folio managerhas thought care5.88
5.01
6.73
4.15
3.97
-0.30
2.82
Equities
fullyaboutwhathis benchmarkis
andwhere his allocationsare relViews Relative to the Domestic-Weighted Benchmark
ativeto it, and has conductedthe
0.01
0.90
0.20
0.50 0.54
Currencies
0.05
type of analysisshown here, he
-1.01
0.18
0.21
-1.45
0.72 0.85
Bonds
-0.01
maynot have a clearidea of what
0.28
2.38
-1.49
2.83
5.24 4.83
2.24
Equities
views his portfoliorepresents.
Implied Views
Once an investor has established
his objectives, an asset allocation
CN
a'
Lr
0a
LU
LU
LU
~:
Domestic
Wlthout
Global
Currency
Basis-Point
Difference
Percentage
Gain
Hedging
Bonds Only
Equities Only
Bonds and Equities
2.14
4.72
4.76
Bonds Only
Equities Only
Bonds and Equities
2.63
5.48
5.50
z
D
-J
49
76
74
22.9
16.1
15.5
z
-j
u
z
106
84
85
49.5
17.8
17.9
39
LU
m
LLI
z
L#)
-J
Historical Simulations
Our simulations of all three strategies use the same basic methodology, the same data and the same
underlying securities. The strategies differ in the sources of views
about excess returns and in the
assets to which those views are
applied. All the simulations use
our approach of adjusting expected excess returns away from
the global equilibrium as a function of investor views.
In each of the simulations, we test
a strategy by performing the following steps. Startingin July 1981
and continuing each month for
the next 10 years, we use data up
to that point in time to estimate a
covariance matrix of returns on
equities, bonds and currencies.
We compute the equilibrium risk
premiums, add views according
to the particularstrategy, and calculate the set of expected excess
returns for all securities based on
combining views with equilibrium.
Figure A
$ 600
Currency Strategy
500
Equilibrium
1
400
300-
200 -
Bond Strategy
00
~~~~~~~~~~Equity
Strategy|
0u
June-'81
Sept-'82
Dec.-'83
Mar.-'85
Sept-'87
June-'86
Mar.-'90 June-'91
Dec.-'88
In simulations of a strategy of
investingin fixed income markets
with high yields, we generate Figure B HistoricalRisk/ReturnTradeoffs,July 1981 - August 1991
views by assumingthat expected
excess returns on bonds are
10abovetheirequilibriumvaluesby
an amountequalto the difference
9
Currency Strategy
between the bond-equivalent
8
yield in thatcountryand the global market-capitalizationEquity Strategy
weighted average bond-equivaU.S. Equities U
6 lent yield.
S;
5-
P4
/ UnhedgedE
wGlobal
/
GlobalHedged
4-
/
2-
LU
cn
^Equilibrium
Bond Strategy
2U.S.
lIBOR
(N
S. Bonds
-J
U
0-
Risk (%)
10
12
14
16
41
Conclusion
r54
0)
0)
cl:
LLJ
views. By adjusting the confi- 6. The equilibrium-risk-premidence in his views, the investor
ums vector HIis given by Hl =
can control how strongly the
8K:W,where 5 is a proportionviews influence the portfolio
ality constant based on the forweights. Similarly,by specifying a
mulas in Black."8
ranking of confidence in different
views, the investor can control 7. The expected excess return,
E[R],is unobservable. It is aswhich views are expressed most
sumed to have a probability
strongly in the portfolio. The indistribution that is proporvestor can express views about
tional to a product of two northe relative performance of assets
mal distributions. The first
as well as their absolute perfordistribution represents equimance.
librium; it is centered at 1I
with a covariance matrix r-,
We hope that our series of examples-designed to illustrate the
where r is a constant. The secinsights that quantitative modelond distribution represents
ing can provide-will stimulate
the investor's views about k
linear combinations of the elinvestment managers to consider,
or perhaps to reconsider, the apements of E(R]. These views
plication of such modeling to
are expressed in the following
form:
their own portfolios.
Appendix
PE[R] =
Wi=
-J
Fz
LL
L/,I
LU
r-
matrixQ.
the
Wis as follows:
0~
LU
Q+
5. Assets excess returns are normally distributed with a covariance matrix L:.
Et =
Pt + l/Xt + 1
* 100
Pt/xt
-
(1 + Rt)FXt-Rt,
FXt=
xt
t1 1
' 100,
a)
0)
ui
co
:
LLJ
LX
0
L/,
-
z
-J
z
L4
43