casemark/building-risk-parity-portfolios

Building Risk Parity Portfolios

When To Use

• Constructing a multi-asset portfolio where each asset class contributes equally to total portfolio risk
• Designing leveraged balanced strategies (e.g., Bridgewater All Weather–style allocations)
• Rebalancing an existing risk parity book to reflect updated covariance estimates
• Comparing risk parity weights against market-cap or equal-weight benchmarks
• Building a volatility-targeted overlay that scales gross exposure to a constant risk budget

Inputs To Gather

• Asset universe: List of asset classes or instruments (e.g., equities, nominal bonds, TIPS, commodities, gold) with ticker-level mapping where applicable
• Return series: Total-return time series for each asset — minimum 10 years monthly, or 3 years daily; confirm frequency and currency [VERIFY]
• Covariance estimation method: Sample covariance, exponentially weighted (half-life), shrinkage (Ledoit-Wolf), or DCC-GARCH — confirm client preference
• Risk-free rate: Specify proxy (3-month T-bill, OIS, SOFR) and whether to subtract from returns before optimization [VERIFY]
• Target portfolio volatility: Annualized vol target for the levered portfolio (common range: 10–15%)
• Leverage constraints: Maximum gross exposure, borrowing cost assumption, margin/collateral rules [VERIFY]
• Rebalance frequency: Daily, weekly, monthly, or threshold-based (e.g., drift > 10% of target weight)
• Lookback window: Rolling window length for covariance estimation (e.g., 60-day, 252-day)

Workflow

1. Compute the covariance matrix

   • Calculate returns at the chosen frequency; annualize if needed (√252 for daily)
   • Apply the selected estimation method; if shrinkage, report shrinkage intensity
   • Validate: check that the matrix is positive semi-definite; flag near-singular conditions

2. Solve for risk parity weights

   • Define the objective: each asset's marginal risk contribution (MRC) equals 1/N of total portfolio volatility
   • MRC_i = w_i × (Σw)_i / σ_p — iterate until MRC_i ≈ MRC_j for all i, j
   • Use numerical optimization (e.g., sequential least squares or Newton's method on the risk-budget Lagrangian)
   • Confirm weights sum to 1.0 (unlevered) or to gross exposure target (levered)

3. Apply leverage scaling

   • Compute unlevered portfolio volatility σ_unlevered from the risk parity weights
   • Leverage multiplier = Target Vol / σ_unlevered
   • Adjusted weights = raw weights × leverage multiplier
   • Subtract borrowing cost from expected return: cost = (gross exposure − 1) × funding rate [VERIFY funding rate assumption]

4. Backtest and stress-test

   • Run rolling or expanding-window backtest; report annualized return, vol, Sharpe, max drawdown, and Calmar ratio
   • Conduct stress scenarios: 2008 GFC, 2013 taper tantrum, 2020 COVID, 2022 rates shock — report portfolio P&L under each
   • Compare against 60/40, equal-weight, and inverse-vol benchmarks

5. Sensitivity analysis

   • Vary lookback window (30d, 60d, 120d, 252d) — show weight stability and turnover impact
   • Vary covariance method — compare sample vs. shrinkage vs. EWMA weights
   • Shock individual asset vols by ±2σ and correlation matrix by ±0.10 — report weight and risk-contribution shifts

6. Document allocation model

   • Final weight table with risk contribution breakdown (absolute and percentage)
   • Gross and net exposure, leverage ratio, estimated borrowing cost drag
   • Rebalance rule specification and estimated annual turnover
   • All assumptions flagged explicitly; mark jurisdiction-dependent constraints with [VERIFY]

Output

Deliver a structured risk parity model package containing:

• Weight schedule: Asset-level weights, risk contributions, and leverage multiplier
• Covariance summary: Correlation heatmap, per-asset annualized vol, eigenvalue decomposition
• Backtest report: Equity curve, rolling Sharpe, drawdown chart, monthly return table
• Stress-test matrix: Scenario returns for the portfolio vs. benchmarks
• Sensitivity exhibits: Weight and turnover impact across parameter variations
• Methodology memo: Estimation method, optimization algorithm, rebalance logic, and all [VERIFY] items

Quality Checks

• Confirm each asset's percentage risk contribution is within ±0.5% of 1/N target after optimization convergence
• Verify portfolio vol matches the stated target (tolerance: ±25 bps annualized)
• Check that weights are non-negative (unless short selling is explicitly permitted) and sum correctly
• Validate that the covariance matrix has no negative eigenvalues
• Ensure backtest does not use future information (no look-ahead bias in rolling windows)
• Cross-check leverage multiplier against margin and regulatory constraints [VERIFY applicable margin rules]
• Confirm borrowing cost assumption reflects current market rates, not stale inputs