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The Journal of Alternative Investments

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Article

Toward Conditional Risk Parity: Improving Risk Budgeting Techniques in Changing Economic Environments

Lionel Martellini, Vincent Milhau and Andrea Tarelli
The Journal of Alternative Investments Summer 2015, 18 (1) 48-64; DOI: https://doi.org/10.3905/jai.2015.18.1.048
Lionel Martellini
is a professor of finance at EDHEC Business School, scientific director of EDHEC-Risk Institute, and a senior scientific advisor at ERI Scientific Beta in Nice, France.
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  • For correspondence: lionel.martellini@edhec.edu
Vincent Milhau
is the deputy scientific director of EDHEC-Risk Institute in Nice, France.
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  • For correspondence: vincent.milhau@edhec.edu
Andrea Tarelli
is a post-doctoral research fellow at Bocconi University in Milan, Italy.
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  • For correspondence: andrea.tarelli@unibocconi.it
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Abstract

Risk parity portfolios are traditionally constructed by choosing historical volatility as the risk measure. In an asset allocation context, this results in a substantial overweighting of bonds versus more volatile asset classes such as stocks: this is a concern in a low bond yield environment, since the presence of mean reversion in the yield implies that bonds are likely to perform poorly in the next future. In this article, we introduce three distinct risk parity strategies, explicitly designed to respond to changes in interest rate levels. Our results indicate that these strategies deliver higher returns when interest rates start to increase back to their long-term levels, and that the maximum Sharpe ratio portfolio, which also incorporates information on expected returns, is a less robust alternative.

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The Journal of Alternative Investments: 18 (1)
The Journal of Alternative Investments
Vol. 18, Issue 1
Summer 2015
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Toward Conditional Risk Parity: Improving Risk Budgeting Techniques in Changing Economic Environments
Lionel Martellini, Vincent Milhau, Andrea Tarelli
The Journal of Alternative Investments Jun 2015, 18 (1) 48-64; DOI: 10.3905/jai.2015.18.1.048

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Toward Conditional Risk Parity: Improving Risk Budgeting Techniques in Changing Economic Environments
Lionel Martellini, Vincent Milhau, Andrea Tarelli
The Journal of Alternative Investments Jun 2015, 18 (1) 48-64; DOI: 10.3905/jai.2015.18.1.048
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  • Article
    • Abstract
    • FROM UNCONDITIONAL TO CONDITIONAL RISK PARITY STRATEGIES
    • CONDITIONAL RISK PARITY I: USING AN INSTANTANEOUS MEASURE OF VOLATILITY
    • CONDITIONAL RISK PARITY II: EXTENDING RISK PARITY TO DOWNSIDE RISK MEASURES
    • CONDITIONAL RISK PARITY III: DEVIATE FROM PARITY IN THE SHORT RUN WHILE BEING AT PARITY IN THE LONG RUN
    • IMPLEMENTATION OF CRP STRATEGIES
    • BENEFITS OF CRP STRATEGIES IN PERIODS OF INCREASES IN INTEREST RATES
    • PERFORMANCE OF RISK PARITY STRATEGIES
    • CONCLUSION
    • APPENDIX
    • ENDNOTES
    • REFERENCES
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