Inter-Temporal Risk Parity: A Constant Volatility Framework for Equities and Other Asset Classes

29 Pages Posted: 25 Jan 2014  

Romain Perchet

Ecole des Hautes Etudes en Sciences Sociales (EHESS); BNP Paribas

Raul Leote de Carvalho

BNP Paribas Investment Partners

Thomas Heckel

BNP Paribas Asset Management

Pierre Moulin

BNP Paribas Investment Partners

Date Written: January 10, 2014

Abstract

Inter-temporal risk parity is a strategy which rebalances between a risky asset and cash in order to target a constant level of risk over time. When applied to equities and compared to a buy and hold strategy it is known to improve the Sharpe ratio and reduce drawdowns. We used Monte Carlo simulations based on a number of time series parametric models from the GARCH family in order to analyze the relative importance of a number of effects in explaining those benefits. We found that volatility clustering with constant returns and the fat tails are the two effects with the largest explanatory power. The results are even stronger if there is a negative relationship between return and volatility. On the other hand, if the Sharpe ratio remains constant over time, the only benefit would arise from an inter-temporal risk diversification effect which is small and has a negligible contribution. Using historical data, we also simulated what would have been the performance of the strategy when applied to equities, corporate bonds, government bonds and commodities. We found that the benefits of the strategy are more important for equities and high yield corporate bonds, which show the strongest volatility clustering and fat tails. For government bonds and investment grade bonds, which show little volatility clustering, the benefits of the strategy have been less important.

Keywords: risk parity, constant volatility, asset allocation, risk budget, GARCH

JEL Classification: G11, G17

Suggested Citation

Perchet, Romain and Carvalho, Raul Leote de and Heckel, Thomas and Moulin, Pierre, Inter-Temporal Risk Parity: A Constant Volatility Framework for Equities and Other Asset Classes (January 10, 2014). Available at SSRN: https://ssrn.com/abstract=2384583 or http://dx.doi.org/10.2139/ssrn.2384583

Romain Perchet

Ecole des Hautes Etudes en Sciences Sociales (EHESS) ( email )

54, boulevard Raspail
Paris, 75006
France

BNP Paribas ( email )

Paris
France

Raul Leote de Carvalho (Contact Author)

BNP Paribas Investment Partners ( email )

Paris
France
0033158972183 (Phone)

Thomas Heckel

BNP Paribas Asset Management ( email )

Paris
France

Pierre Moulin

BNP Paribas Investment Partners ( email )

Paris
France

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