Managing Risks in a Risk-On/Risk-Off Environment
Marcos Lopez de Prado
Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC
September 23, 2012
Every structure has natural frequencies. Minor shocks in these frequencies can bring down any structure, e.g. a bridge. An Investment Universe also has natural frequencies, characterized by its eigenvectors. A concentration of risks in the direction of any such eigenvector exposes a portfolio to the possibility of greater than expected losses (indeed, maximum risk for that portfolio size), even if that portfolio is below the risk limits. This is particularly dangerous in a risk-on/risk-off regime. Managing Risk is not only about limiting its amount, but also controlling how this amount is concentrated around the natural frequencies of the investment universe.
Number of Pages in PDF File: 50
Keywords: Risk Concentration, Eigenvectors, Eigen-risk decomposition, Risk-on/Risk-off
JEL Classification: C01, C02, C61, D53, G11
Date posted: September 23, 2012 ; Last revised: May 26, 2014
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