EDHEC-Risk Institute study shows that it is possible to construct improved forms of risk parity strategies

Written on 16 June 2014.

The paper looks at the topical issue of risk parity. It has become increasingly apparent that a portfolio that seems to be well-balanced in terms of dollar contributions can be extremely concentrated in terms of risk contributions because of differences in volatility and pairwise correlation levels amongst the constituents.

Risk parity has become an increasingly popular risk management methodology within and across asset classes. While intuitively appealing, this approach suffers from one major shortcoming, namely the fact that it is not explicitly sensitive to changes in market conditions. In particular, using the risk parity approach in an asset allocation context inevitably leads to a substantial overweighting of bonds versus equities, which might be a concern in a low bond yield and high dividend yield economic environment.

In this paper the authors introduce three distinct conditional risk parity strategies, explicitly designed to optimally respond to changes in state variables.

A copy of “Towards Conditional Risk Parity – Improving Risk Budgeting Techniques in Changing Economic Environments” can be downloaded via the following link:

EDHEC Publication Towards Conditional Risk Parity – Improving Risk Budgeting Techniques in Changing Economic Environments

This research was supported by Lyxor as part of the research chair at EDHEC-Risk Institute on “Risk Allocations Solutions.”  This chair is examining performance portfolios with improved hedging benefits, hedging portfolios with improved performance benefits, and inflation risk and asset allocation solutions.

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