Uncertain Risk Parity

7 Pages Posted: 24 Jun 2019 Last revised: 7 Oct 2020

See all articles by Anish Shah

Anish Shah

Investment Grade Modeling

Date Written: June 18, 2019


Risk parity is a portfolio construction technique that scales sections of a portfolio—e.g., stocks, bonds, currencies, commodities—so that forecasted contributions to net portfolio risk match the budget. Because risks are measured from a point-estimate of covariance, the method is subject to problems of estimation error. This paper treats covariance as uncertain in order to find a risk parity weighting that doesn't count on perfectly optimized hedges and is robust to changes in regime.

Separately, of general interest are the uncertain risk contributions calculated en route. Reporting a portfolio's uncertain risk decomposition puts a band around numbers and reveals fragility. For example, market could seem hedged in a long-short portfolio but, examined with uncertainty, surface as the biggest risk when values fall across estimates' range of error instead of at a point.

Keywords: Covariance, Estimation Error, Factor Models, Portfolio Construction, Regularization, Risk Parity, Uncertainty

JEL Classification: G11, C44, C61

Suggested Citation

Shah, Anish, Uncertain Risk Parity (June 18, 2019). Available at SSRN: https://ssrn.com/abstract=3406321 or http://dx.doi.org/10.2139/ssrn.3406321

Anish Shah (Contact Author)

Investment Grade Modeling ( email )

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