Risk Parity and Risk Budgeting: an empirical application using common well-diversified portfolios

Volatility of financial assets comes as a natural consequence of an asset’s exposure to a variety of sources of risk; risk measurement, therefore, plays an important role in the asset management industry. In the field of portfolio management, risk measurement is traditionally considered as a successive step relatively to portfolio construction. However, particularly due to the financial crisis of 2008, its role has shifted over time to backwards steps, more specifically to the asset allocation phase. Firstly, a risk-based approach has been proposed in order to strategically rebalance existing portfolios: Risk Budgeting. The adjustment of actual portfolio weights comes as a result of a sound analysis of the portfolio volatility, which is decomposed into marginal risk contributions in order to understand the amount of risk carried on by each asset class. More recently, risk measurement has been directly applied to in the asset allocation phase in order to build portfolios such that each asset class equally contributes in terms of volatility to overall portfolio uncertainty, which are commonly defined as Risk Parity Portfolios. Meanwhile, the financial industry has been proposing a variety of well-diversified portfolios, with a limited exposure to the stock and bond market and a new attention to alternative investments, such as real estate, and to raw materials, such as the most valuable over centuries, gold. After introducing the Risk Budgeting approach and Risk Parity Portfolios, the last chapter of the thesis provides an empirical application in which a risk-allocation analysis of the latter well-diversified portfolios and a comparison with portfolios obtained according to the risk parity construction method are presented.