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

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Date posted: September 23, 2012 ; Last revised: May 26, 2014

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

Contact Information

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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