Managing risk exposures using the risk budgeting approach
AbstractThe ongoing economic crisis has profoundly changed the industry of the asset management, by putting risk management at the heart of most investment processes. This new risk-based investment style does not rely on returns forecasts and is therefore assumed to be more robust. In 2011, it has particularly encountered a great success with the achievement of minimum variance, ERC and risk parity strategies in portfolios of several large institutional investors. These portfolio constructions are special cases of a more general class of allocation models, known as the risk budgeting approach. In a risk budgeting portfolio, the risk contribution from each component is equal to the budget of risk defined by the portfolio manager. Unfortunately, even if risk budgeting techniques are widely used by market practitioners, they are few results about the behavior of such portfolios in the academic literature. In this paper, we derive the theoretical properties of the risk budgeting portfolio and show that its volatility is located between those of minimum variance and weight budgeting portfolios. We also discuss the existence, uniqueness and optimality of such a portfolio. In a second part of the paper, we propose several applications of risk budgeting techniques for risk-based allocation, like risk parity funds and strategic asset allocation, and equity and bond alternative indexations.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 37246.
Date of creation: Jan 2012
Date of revision:
Risk budgeting; risk management; risk-based allocation; equal risk contribution; diversification; concentration; risk parity; alternative indexation; strategic asset allocation;
Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
This paper has been announced in the following NEP Reports:
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Ravi Jagannathan & Tongshu Ma, 2003.
"Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps,"
Journal of Finance,
American Finance Association, vol. 58(4), pages 1651-1684, 08.
- Ravi Jagannathan & Tongshu Ma, 2002. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," NBER Working Papers 8922, National Bureau of Economic Research, Inc.
- Roncalli, Thierry, 2010. "Understanding the Impact of Weights Constraints in Portfolio Theory," MPRA Paper 36753, University Library of Munich, Germany.
- Bruder, Benjamin & Hereil, Pierre & Roncalli, Thierry, 2011. "Managing sovereign credit risk in bond portfolios," MPRA Paper 36673, University Library of Munich, Germany.
- Ledoit, Olivier & Wolf, Michael, 2003.
"Improved estimation of the covariance matrix of stock returns with an application to portfolio selection,"
Journal of Empirical Finance,
Elsevier, vol. 10(5), pages 603-621, December.
- Olivier Ledoit & Michael Wolf, 2001. "Improved estimation of the covariance matrix of stock returns with an application to portofolio selection," Economics Working Papers 586, Department of Economics and Business, Universitat Pompeu Fabra.
- Clark, Gordon L. & Caerlewy-Smith, Emiko & Marshall, John C., 2006. "Pension fund trustee competence: decision making in problems relevant to investment practice," Journal of Pension Economics and Finance, Cambridge University Press, vol. 5(01), pages 91-110, March.
- Isabelle Bajeux-Besnainou & James V. Jordan & Roland Portait, 2003. "Dynamic Asset Allocation for Stocks, Bonds, and Cash," The Journal of Business, University of Chicago Press, vol. 76(2), pages 263-288, April.
- Th\'eophile Griveau-Billion & Jean-Charles Richard & Thierry Roncalli, 2013.
"A Fast Algorithm for Computing High-dimensional Risk Parity Portfolios,"
- Griveau-Billion, Théophile & Richard, Jean-Charles & Roncalli, Thierry, 2013. "A Fast Algorithm for Computing High-dimensional Risk Parity Portfolios," MPRA Paper 49822, University Library of Munich, Germany.
- Serge Darolles & Christian Gouriéroux & Emmanuelle Jay, 2012. "Robust Portfolio Allocation with Systematic Risk Contribution Restrictions," Working Papers 2012-35, Centre de Recherche en Economie et Statistique.
- Roncalli, Thierry & Weisang, Guillaume, 2012. "Risk Parity Portfolios with Risk Factors," MPRA Paper 44017, University Library of Munich, Germany.
- Roncalli, Thierry, 2013. "Introducing Expected Returns into Risk Parity Portfolios: A New Framework for Tactical and Strategic Asset Allocation," MPRA Paper 49821, University Library of Munich, Germany.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Ekkehart Schlicht).
If references are entirely missing, you can add them using this form.