Portfolio Construction (Treynor and Black

model)

Assuming that all securities are fairly priced,

we can write the index model for security i as

ri − rf = βi(rm − rf ) + ei

Assumptions:

M is the efficient portfolio. We have informa-

tion on its return rM and the variance σM2 .

Objective:

To form an active portfolio to be mixed with

the market portfolio.

12
Suppose we have some mispriced securities, we
can write the index model

rk − rf = αk + βk (rm − rf ) + ek

where αK represents the extra expected return

(abnormal return) attributable to mispricing of
the security.

If all αk ’ turn out to be zero, there is no need

to depart from the market portfolio. However,
this is a remote possibility.

Suppose we have an active portfolio A based

on the mispriced securities with αA, βA and
σ 2(eA) parameters.

13
 2
Cov(rA, rM ) = βAσM
2 = β 2 σ 2 + σ 2(e )
σA A M A

E(rA) = αA + rf + βA[E(rM ) − rf ]

The optimal combination of the market portfo-

lio and the active portfolio can be found based
on a similar strategy that we used to construct
an optimal portfolio P.

rp(w) = wrA + (1 − w)rM

Maximization problem:

rp(w) − rf
max
w σp

14
Maximization problem:

rp(w) − rf
max
w σp

Solution

w0
w∗ =
1 + (1 − βA)w0

where

αA/σ 2(eA)
w0 = 2
[E(rM ) − rf ]/σM

Reward to variability of the optimal portfolio

is

α2
Sp2 = SM
2 +( A )
σ 2(eA)
15
The above shows that the highest Sharpe ratio
for the risky portfolio can be attained when we
construct an active portfolio which maximizes
the value of αA/σ(eA).

Therefore we can find the optimal weights of

active portfolio as

αk /σ 2(eA)
wk = Pn 2
i=1 αi/σ (ei )

For more reading and examples: refer to BMK,

chapter on The theory of active portfolio man-
agement.
Consider a single index model

rp = α + βprm + ei

2
Cov(rP , rM ) = βpσM

and

V ar(rp) = βp2σM
2 + σ 2(e )
P

Therefore,

2
βpσM
Corr(rp, rM ) = q
βp2σM
2 + σ 2 (e )(σ )
P M

βpσM
Corr(rp, rM ) = q
βp2σM
2 + σ 2(e )
P

16
Active Portfolio Selection

CAL

A
P
CML