Risk Parity is Not Short Volatility (Not That There's Anything Wrong with Short Volatility)

55 Pages Posted: 16 Aug 2019

See all articles by Benjamin Hood

Benjamin Hood

AQR Capital Management, LLC

John Huss

AQR Capital Management, LLC

Roni Israelov

AQR Capital Management, LLC

Matthew Klein

AQR Capital Management, LLC

Date Written: August 15, 2019

Abstract

There have been increasingly frequent claims that risk parity strategies are hiding an implicit short volatility exposure or behave as though they are short volatility. In order to test the veracity of these claims, we simulate stylized versions of three-asset-class (equity, fixed income, and commodities) risk parity and short volatility strategies, and we compare the trading behavior and returns of each. We conclude that the two strategies’ similarities are overstated, and we find no empirical evidence to support the claimed hidden exposure. Even with conservative assumptions designed to heighten the similarity of the two strategies, their trades are uncorrelated (or even slightly negative correlated) at almost any horizon. Though their returns are moderately correlated, the correlation is explained by common exposure to equities and bonds, not by common exposure to gamma or other forms of convexity. Controlling for these static underlying exposures, we find that the returns of the two strategies are almost orthogonal, with short volatility explaining less than one percent of the total variance of risk parity returns. We extend our analysis to consider equity and fixed income asset classes in isolation, where we observe very similar results.

Keywords: Risk Parity; Volatility Control; Volatility; Short Volatility; Volatility Risk Premium; Variance Risk Premium; Options; Hedging

JEL Classification: G10; G11; G12

Suggested Citation

Hood, Benjamin and Huss, John and Israelov, Roni and Klein, Matthew, Risk Parity is Not Short Volatility (Not That There's Anything Wrong with Short Volatility) (August 15, 2019). Available at SSRN: https://ssrn.com/abstract=3432438 or http://dx.doi.org/10.2139/ssrn.3432438

Benjamin Hood

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

John Huss

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Roni Israelov (Contact Author)

AQR Capital Management, LLC ( email )

Two Greenwich Plaza, 3rd Floor
Greenwich, CT 06830
United States

HOME PAGE: http://www.aqrcapital.com

Matthew Klein

AQR Capital Management, LLC ( email )

Greenwich, CT
United States
203-742-3624 (Phone)

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