The Factor Tau in the Black-Litterman Model

Abstract

This paper considers the factor tau (τ) in the Black-Litterman model. τ is one of the more confusing aspects of the model, as authors provide contradictory information regarding its use and calibration. We will consider the origin of the mixed-estimation model used in the Black-Litterman Model so that we can develop a richer understanding of τ and its place in the model. We will discuss the various models which use the name Black-Litterman and how they do or do not use τ. Finally, we will show several ways to calibrate τ when using the canonical Black-Litterman model.