# The Treynor-Black Model

- Treynor and Black developed a portfolio optimization model that seeks to maximize a portfolio's Sharpe Ratio through a combination of an actively managed portfolio component built with a few select mispriced securities and a passively managed market index portfolio component.
- Treynor-Black assumes that markets are highly, but no perfectly efficient.
- Macroeconomic forecasting can be applied to calculate the expected return and standard deviation of the portfolio.
- Securities can be assessed for mispricing by comparing the forecasted return with the required return based on the Security Market Line.
- Mispricing presents the opportunity for abnormal return, where abnormal return is the analyst's expected return minus the required return dictated by the Security Market Line.
- The cost of less than full market diversification is reflected by the variance of the residual error of the active securities.

## Treynor-Black Process

Economists create forecasts to derive inputs for the security representing the market portfolio.

Security analysts isolate the few securities mispriced by the market.

The portfolio manager constructs the optimal portfolio.

Post investment period quality analysis can be done by:

Measuring the correlation squared of the security analyst's forecasted alphas to actual alphas realized.

A high correlation will give the portfolio manager confidence in the analysts' abilities to correctly identify mispriced securities in the future.

## Limitations of Treynor-Black for Investors

- Some investors may prohibit their portfolio managers from short selling, which limits the ability to exploit overpriced assets.
- Treynor-Black relies on successfully forecasting alpha, which is incredibly difficult for even well trained analysts.

LESSONS

- CFA Level 2: Portfolio Management – Introduction
- Mean-Variance Analysis Assumptions
- Expected Return and Variance for a Two Asset Portfolio
- The Minimum Variance Frontier & Efficient Frontier
- Diversification Benefits
- The Capital Allocation Line – Introducing the Risk-free Asset
- The Capital Market Line
- CAPM & the SML
- Adding an Asset to a Portfolio – Improving the Minimum Variance Frontier
- The Market Model for a Security’s Returns
- Adjusted and Unadjusted Beta
- Multifactor Models
- Arbitrage Portfolio Theory (APT) – A Multifactor Macroeconomic Model
- Risk Factors and Tracking Portfolios
- Markowitz, MPT, and Market Efficiency
- International Capital Market Integration
- Domestic CAPM and Extended CAPM
- Changes in Real Exchange Rates
- International CAPM (ICAPM) - Beyond Extended CAPM
- Measuring Currency Exposure
- Company Stock Value Responses to Changes in Real Exchange Rates
- ICAPM vs. Domestic CAPM
- The J-Curve – Impact of Exchange Rate Changes on National Economies
- Moving Exchange Rates and Equity Markets
- Impacts of Market Segmentation on ICAPM
- Justifying Active Portfolio Management
- The Treynor-Black Model
- Portfolio Management Process
- The Investor Policy Statement

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