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

50 Pages Posted: 23 Sep 2012 Last revised: 26 May 2014

Marcos Lopez de Prado

Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC

Date Written: September 23, 2012

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

Suggested Citation

Lopez de Prado, Marcos, Managing Risks in a Risk-On/Risk-Off Environment (September 23, 2012). Available at SSRN: https://ssrn.com/abstract=2150877 or http://dx.doi.org/10.2139/ssrn.2150877

Marcos Lopez de Prado (Contact Author)

Guggenheim Partners, LLC ( email )

330 Madison Avenue
New York, NY 10017
United States

HOME PAGE: http://www.QuantResearch.org

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.lbl.gov

Harvard University - RCC ( email )

26 Trowbridge Street
Cambridge, MA 02138
United States

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

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