Second-Order Risk of Alternative Risk Parity Strategies

30 Pages Posted: 26 Dec 2017 Last revised: 8 Feb 2019

See all articles by Simone Bernardi

Simone Bernardi

University of Zurich - Department of Banking and Finance

Markus Leippold

University of Zurich - Department of Banking and Finance; University of Zurich - Faculty of Economics, Business Administration and Information Technology

Harald Lohre

Invesco; Centre for Endowment Asset Management, Cambridge Judge Business School, University of Cambridge; Centre for Financial Econometrics, Asset Markets and Macroeconomic Policy, Lancaster University Management School

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Date Written: March 2, 2018

Abstract

The concept of second-order risk operationalizes the estimation risk in portfolio construction induced by model uncertainty. We study its contribution to the realized volatility of recently developed risk parity strategies. For each strategy, we derive closed-form solutions for the second-order risk, subsequently illustrated in empirical analysis based on real market data. The results suggest a relation between the contribution of second-order risk and the sensitivity of a portfolio to single eigenvectors of the covariance matrix of assets' returns. Among the strategies considered, we find the principal risk parity strategy, that invests equally in each eigenvector underlying the variance--covariance matrix, to be immune to second-order risk. For the other strategies, second-order risk can be partially mitigated by means of statistical methods.

Keywords: Estimation Risk, Second-Order Risk, Portfolio Construction, Risk Parity, Diversification

JEL Classification: G11, D81

Suggested Citation

Bernardi, Simone and Leippold, Markus and Lohre, Harald, Second-Order Risk of Alternative Risk Parity Strategies (March 2, 2018). Available at SSRN: https://ssrn.com/abstract=3090624 or http://dx.doi.org/10.2139/ssrn.3090624

Simone Bernardi

University of Zurich - Department of Banking and Finance ( email )

Schönberggasse 1
Zürich, 8001
Switzerland

Markus Leippold (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

University of Zurich - Faculty of Economics, Business Administration and Information Technology ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

Harald Lohre

Invesco ( email )

An der Welle 5
Frankfurt am Main, 60322
Germany

HOME PAGE: http://www.de.invesco.com/portal/site/de-de/home/ueber-uns/invesco-quantitative-strategies/

Centre for Endowment Asset Management, Cambridge Judge Business School, University of Cambridge

Cambridge
United Kingdom

HOME PAGE: http://https://www.jbs.cam.ac.uk/faculty-research/centres/ceam/

Centre for Financial Econometrics, Asset Markets and Macroeconomic Policy, Lancaster University Management School

Bailrigg
Lancaster LA1 4YX
United Kingdom

HOME PAGE: http://www.lancaster.ac.uk/lums/research/research-centres/financial-econometrics/

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