Treynor-Black Model - Explained
What is the Treynor-Black Model?
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Table of ContentsWhat is the Treynor Black Model?How Does the Treynor Black Model Work?
What is the Treynor Black Model?
A Treynor Black model seeks to optimize a portfolios Sharpe Ratio by combining an active investment with underpriced securities and a passively managed index fund.
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How Does the Treynor Black Model Work?
Published in 1973 by Jack Treynor and Fisher Black, this model implies that a market is highly efficient, but not perfect. It also analyses the possibility of investors making excess profits from underpriced securities or stocks. Passive market portfolios contain securities according to their market value, and a general assumption is that expected returns can only be estimated by macroenomic forecasting (an attempt to predict the future of an economy by combining important and generally accepted indicators). Each security is measured according to the ratio its excess returns per benchmark index to its unsystematic risk (risk specific to the investment alone) in an active portfolio. This ratio is known as the Treynor-Black or appraisal ratio, and it measures the value of which an investment adds to a portfolio. In this model, a security which has high excess returns will be given more value, while those with low unsystematic risk will be given low values. The Treynor-Black model is less popular among investors due to the difficulty of picking stocks as required by the model, and restriction on short selling (an investor borrows a stock, sells it to a buyer, and then buy it back at a lower price and return it to the lender) prevent the opportunity for excess returns.