Volatility Scaling's Impact on the Sharpe Ratio

10 Pages Posted: 15 Nov 2018

Date Written: November 6, 2018

Abstract

We study the econometric properties of dynamic risk parity, which volatility scales to equalise risk through time using the precision process, the inverse of the time-varying volatility. A particular focus is on the impact of the Sharpe ratio. We give necessary and suffcient conditions that volatility scaling improves the Sharpe ratio of an investment. We approximate the Sharpe improvement using the sum of two terms: one determined by the convexity of the precision and the other the covariance of the precision and conditional mean. We show that empirically this approximation is very accurate and we document the relative importance of the two terms.

Keywords: asset allocation, precision process, risk parity, sharpe ratio, time-varying volatility

Suggested Citation

Hoyle, Edward and Shephard, Neil, Volatility Scaling's Impact on the Sharpe Ratio (November 6, 2018). Available at SSRN: https://ssrn.com/abstract=3279787 or http://dx.doi.org/10.2139/ssrn.3279787

Edward Hoyle

Man AHL ( email )

Riverbank House
2 Swan Lane
London, EC4R 3AD
United Kingdom

Neil Shephard (Contact Author)

Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

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