Risk parity is a powerful portfolio construction approach that achieves diversification in terms of asset risk exposures. It masterfully utilizes information on volatilities and correlations to balance a portfolio such that each asset in the portfolio contributes equally to total portfolio risk. This article seeks to explain the benefits of risk parity as an approach to portfolio construction, as well as outline the theoretical foundations of this approach in as clearer manner as possible. For reader clarity, both summation notation and matrix notation are used in derivations. This article has been written in response to the author’s own challenges with finding a clear, holistic overview of the risk parity approach and its derivation.
Article available on SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4250812
Keywords: risk parity, portfolio construction, portfolio management, risk management, risk, Carrodus, trading, linear algebra