Balanced Baskets: A New Approach to Trading and Hedging Risks
David H. Bailey
Lawrence Berkeley National Laboratory; University of California, Davis
Marcos Lopez de Prado
Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC
May 24, 2012
Journal of Investment Strategies (Risk Journals), Vol.1(4), Fall 2012
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.
Number of Pages in PDF File: 44
Keywords: Trading baskets, hedging baskets, equal risk contribution, maximum diversification, subset correlation
JEL Classification: C01, C02, C61, D53, G11
Date posted: May 24, 2012 ; Last revised: September 8, 2012