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Second-Order Risk of Alternative Risk Parity Strategies


Bernardi, Simone; Leippold, Markus; Lohre, Harald (2019). Second-Order Risk of Alternative Risk Parity Strategies. SSRN 3090624, University of Zurich.

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.

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.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:1 January 2019
Deposited On:05 Jun 2019 07:16
Last Modified:31 Oct 2019 08:06
Series Name:SSRN
ISSN:1556-5068
OA Status:Green
Publisher DOI:https://doi.org/10.2139/ssrn.3090624
Official URL:https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3090624
Other Identification Number:merlin-id:16014

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