Balanced Baskets: A New Approach to Trading and Hedging Risks

Journal of Investment Strategies (Risk Journals), Vol.1(4), Fall 2012

44 Pages Posted: 24 May 2012 Last revised: 8 Sep 2012

See all articles by David H. Bailey

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Marcos Lopez de Prado

AQR Capital Management, LLC; Cornell University - Operations Research & Industrial Engineering; RCC - Harvard University

Date Written: May 24, 2012

Abstract

A basket is a set of instruments that are held together because its statistical profile delivers a desired goal, such as hedging or trading, which cannot be achieved through the individual constituents or even subsets of them. Multiple procedures have been proposed to compute hedging and trading baskets, among which balanced baskets have attracted significant attention in recent years. Unlike Principal Component Analysis (PCA) style of methods, balanced baskets spread risk or exposure across their constituents without requiring a change of basis. Practitioners typically prefer balanced baskets because their output can be understood in the same terms for which they have developed an intuition.

We review three methodologies for determining balanced baskets, analyze the features of their respective solutions and provide Python code for their calculation. We also introduce a new method for reducing the dimension of a covariance matrix, called Covariance Clustering, which addresses the problem of numerical ill-conditioning without requiring a change of basis.

Keywords: Trading baskets, hedging baskets, equal risk contribution, maximum diversification, subset correlation

JEL Classification: C01, C02, C61, D53, G11

Suggested Citation

Bailey, David H. and López de Prado, Marcos, Balanced Baskets: A New Approach to Trading and Hedging Risks (May 24, 2012). Journal of Investment Strategies (Risk Journals), Vol.1(4), Fall 2012. Available at SSRN: https://ssrn.com/abstract=2066170 or http://dx.doi.org/10.2139/ssrn.2066170

David H. Bailey

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.davidhbailey.com

University of California, Davis ( email )

One Shields Avenue
Davis, CA 95616
United States

HOME PAGE: http://www.davidhbailey.com

Marcos López de Prado (Contact Author)

AQR Capital Management, LLC ( email )

One Greenwich Plaza
Greenwich, CT 06830
United States

HOME PAGE: http://www.aqr.com

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

RCC - Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

HOME PAGE: http://www.rcc.harvard.edu

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