Reverse optimization and capital asset pricing model in the application of the Black Litterman portfolio

Abstract

In the application of the Black Litterman model on portfolio construction, the terms of reverse optimization and Capital Asset Pricing Model (CAPM) are often associated with the Black Litterman process. This study explains the Black Litterman model from two perspectives: reverse optimization and the CAPM formula. Two portfolios are built with different starting points and without any lambda difference as a risk aversion coefficient, a scalar tau, and views return in the Black Litterman strategy. Both models are applied in the Indonesian stock market, and the empirical comparison of both portfolios are demonstrated. The result shows that both approaches can build a portfolio using the Black Litterman with a similar weight allocation.