What is risk parity trading?

What is risk parity trading?

What Is Risk Parity? Risk parity is a portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio. The risk parity strategy modifies the modern portfolio theory (MPT) approach to investing through the use of leverage.

How does risk parity work?

Risk parity uses leverage to reduce and diversify the equity risk in a portfolio while still targeting long-term performance. The prudent use of leverage in liquid assets can reduce the volatility of equities alone. Risk parity seeks equity-like returns for portfolios with reduced risk.

What is risk parity wealthfront?

Risk Parity is a methodology to allocate capital across multiple asset classes, much like Modern Portfolio Theory (MPT), also known as mean-variance optimization. Historically, Risk Parity has generated better returns for a given level of portfolio risk than MPT, which is the most common form of asset allocation.

How do you create a risk parity?

The idea behind risk parity is simple: build a portfolio of uncorrelated assets, weighted according to their volatilities, and use modest leverage to boost returns while keeping volatility tolerable.

Why is risk parity so popular?

This greater expected return for the same risk is the reason Risk Parity is so popular among institutions.

How to build a risk parity portfolio?

Now let’s consider a Risk Parity portfolio constructed to have the same volatility as the MPT based 60/40 stock/bond portfolio. This portfolio can be constructed by first equalizing the risk contributions of the two asset classes and then applying leverage to achieve a target volatility of 11.0%.

What is the expected return on the unleveraged risk parity portfolio?

The expected return on the unleveraged Risk Parity portfolio is 4.46% (20.5% * 6.25% + 79.5% * 4.00%). After applying 2x leverage, the expected gross return rises to 8.92% (4.46% * 2), but the investor has to pay 3.05% in net financing costs, resulting in a net expected return of 5.87% (8.92% – 3.05%).

How often should a risk parity strategy be rebalanced?

Finally, the composition of a Risk Parity strategy needs to be periodically rebalanced in response to changes in the expected volatility of the underlying asset classes.