Towards Conditional Risk Parity — Improving Risk Budgeting Techniques in Changing Economic Environments

This chair is examining performance portfolios with improved hedging benefits, hedging portfolios with improved performance benefits, and inflation risk and asset allocation solutions. The current paper, “Towards Conditional Risk Parity – Improving Risk Budgeting Techniques in Changing Economic Environments” 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. In this context, risk parity, which assigns the same contribution to portfolio risk to all assets, 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, we introduce three distinct conditional risk parity strategies, explicitly designed to optimally respond to changes in state variables that have been used in the literature as proxies for the stochastically time-varying opportunity set. In an empirical analysis, we document the superiority in various economic regimes of such conditional risk parity strategies with respect to standard unconditional risk parity techniques.