The Risk Parity Principle Applied on a Corporate Bond Index Using Duration Times Spread
31 Pages Posted: 10 Sep 2016
Date Written: September 9, 2016
In this paper, we apply the principle of Equal Risk Contribution (ERC) to a corporate bond index, an asset class so far left behind in this literature. Specifically, we rely on the Duration Times Spread (DTS) and demonstrate that it is a coherent metric for bond risk. We construct indexes based on sector - issuer - and bond level using structured block correlation matrices, weights being inversely proportional to DTS. Our results provide evidence that applying ERC using DTS in the index design significantly improves corporate bond index risk-adjusted returns. It appears that the higher the granularity is, the higher will be the risk-adjusted performance enhancements. More generally, the ERC application we present seems to be a valuable trade-off between heuristic and more complex risk-modeling based weighting schemes.
Keywords: Equal Risk Contribution, Risk Parity, Smart Beta, Risk Measure, Risk-Based Indexing
JEL Classification: G10, G11, C60
Suggested Citation: Suggested Citation