Chapter 21. Risk Budgeting

ALEXANDRE SCHUTEL DA SILVA

Vice President, Quantitative Investments Group, Lehman Brothers Asset Management

WAI LEE, PhD

Managing Director, Head of Quantitative Investments Group, Lehman Brothers Asset Management

BOBBY PORNROJNANGKOOL, PhD

Vice President, Quantitative Investments Group, Lehman Brothers Asset Management

Abstract: Risk budgeting is the discipline of allocating risk in an investment portfolio, and is closely related to the principles of modern portfolio theory. Its use is widespread in the investment industry, ranging from the relatively modest task of measuring exposures within an individual portfolio to enterprise-wide efforts to quantify and contain risk at major financial companies. In assessing risk, attention is often paid not only to normal distributions of potential outcomes, but also to so-called fat-tail risk, which relates to unlikely events that may prove especially severe in their impact. In risk budgeting, practitioners tend to gauge the interaction of assets relative to each other and to benchmark indices, relying on complex underlying algorithms and powerful computer programs in an effort to build models that will stand up to scrutiny both on a theoretical basis and under real world conditions.

Keywords: risk budgeting, modern portfolio theory (MPT), mean-variance analysis, asset allocation, portfolio selection, value at risk (VaR), measurement, continuous probability distribution, skewness, kurtosis, semivariance, normal distribution, ...

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