The Black-Litterman Model: Incorporating the Country Risk as Unpriced Risk Factor
Black and Litterman extended the work on asset allocation beyond traditional mean-variance framework and claimed that asset allocation based upon traditional model had not attracted the portfolio managers. However, it assumes that risk can be completely characterized by covariances and it built upon the same assumption as the capital asset pricing model. After globalization, cross country investment has increased significantly so country risk is an important risk factor that needs to be considered. This study explores the ‘country risk’ as unpriced risk factor in Black-Litterman asset allocation framework and develops augmented Black-Litterman formula (BL-H) for tactical asset allocation decisions in emerging equity market. This study also identifies the ‘diverse but related’ drivers of investor’s views for estimation of quantitative views as input into the BL-H model. The BL-H model outperformed the original model in Pakistani market as it has relatively less short positions, more number of positive weight, less variance, and high value of excess sharp ratio. Therefore BL-H model is more appropriate on mathematical and empirical grounds than original model to disperse country risk.
Index Terms- Asset Allocation, Black-Litterman model, Country Risk, Mean-variance criteria