Risk budgeting is a management process that many large institutional investors are adopting. Much of the philosophy and discipline of risk budgeting can be extremely useful for hedge funds, although practiced on a less formal basis than by large institutions. Understanding what risk budgeting is will prepare hedge funds to communicate with large institutional clients in a language they understand.
The goal of risk budgeting is clear: To “spend” a unit of risk efficiently so as to maximize return. However, there is no clear methodology, and no accepted definition. Ask ten “experts” to define risk budgeting and you will get ten—or maybe eleven—answers. This chapter uses an analogy familiar to most people—financial budgeting ...