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Network Risk Parity: graph theory-based portfolio construction

Author

Listed:
  • Vito Ciciretti
  • Alberto Pallotta

    (Middlesex University)

Abstract

This study presents network risk parity, a graph theory-based portfolio construction methodology that arises from a thoughtful critique of the clustering-based approach used by hierarchical risk parity. Advantages of network risk parity include: the ability to capture one-to-many relationships between securities, overcoming the one-to-one limitation; the capacity to leverage the mathematics of graph theory, which enables us, among other things, to demonstrate that the resulting portfolios is less concentrated than those obtained with mean-variance; and the ability to simplify the model specification by eliminating the dependency on the selection of a distance and linkage function. Performance-wise, due to a better representation of systematic risk within the minimum spanning tree, network risk parity outperforms hierarchical risk parity and other competing methods, especially as the number of portfolio constituents increases.

Suggested Citation

  • Vito Ciciretti & Alberto Pallotta, 2024. "Network Risk Parity: graph theory-based portfolio construction," Journal of Asset Management, Palgrave Macmillan, vol. 25(2), pages 136-146, March.
    • Handle: RePEc:pal:assmgt:v:25:y:2024:i:2:d:10.1057_s41260-023-00347-8
    DOI: 10.1057/s41260-023-00347-8
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    References listed on IDEAS

    as
    1. Ole E. Barndorff-Nielsen & Neil Shephard, 2004. "Econometric Analysis of Realized Covariation: High Frequency Based Covariance, Regression, and Correlation in Financial Economics," Econometrica, Econometric Society, vol. 72(3), pages 885-925, May.
    2. R. Mantegna, 1999. "Hierarchical structure in financial markets," The European Physical Journal B: Condensed Matter and Complex Systems, Springer;EDP Sciences, vol. 11(1), pages 193-197, September.
    3. Výrost, Tomas & Lyócsa, Štefan & Baumöhl, Eduard, 2019. "Network-based asset allocation strategies," The North American Journal of Economics and Finance, Elsevier, vol. 47(C), pages 516-536.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Portfolio construction; Graph theory; Hierarchical clustering; Eigenvalues;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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