Managing Risks in a Risk-On/Risk-Off Environment

Abstract

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.

Keywords: Risk Concentration, Eigenvectors, Eigen-risk decomposition, Risk-on/Risk-off

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