Risk Diversification Strategies - Research Paper Example

Wew= 1 Where We weigh the scheme N is the number of stocks. In addition; the following optimality conditions assumed μi = μ σi = σ ρij = ρ μi is the expected return on stock I, σi is the volatility for stock I, ρij is the correlation between stocks i and j.

Advantages of EWQ i. They are attractive because they avoid the concentration and trend following cap-weighted indices. ii. They lead to higher Sharpe ratios compared to their cap-weighted portfolio methods. iii. It is a simple way of de-concentrating a portfolio and allows us to benefit from systematic rebalancing back to fixed weights. Disadvantages of EWQ i. It does not take into account historical data of the investments, which may lead to lower returns. ii. By giving equal importance to each investment, better-performing investments may be overlooked hence missing out on higher returns. 2.2 Diversified Risk Parity (DRP) Portfolio Risk parity is an investment approach in a portfolio that focuses on allocation or risk rather than capital allocation.

To achieve a higher Sharpe ratio in a risk parity portfolio, the portfolio's risk should be adjusted to the same level (Petkova and Zhang, 2005, 192). According to (Maillard, Roncalli, and Teiletche, 2010, 62), the risk-parity portfolios would be optimal Maximum Sharpe Ratio (MSR) portfolios if the Sharpe ratios and correlation were identical for all investments. The portfolio weights are proportional to the inverse of the volatility (Maillard, Roncalli and Teiletche, 2010, 65): WDRP= Where 1 is a vector of ones σ is the vector of volatilities Advantages of DRP i.

It considers the risk of the investment; hence it works to minimize the risk of the overall portfolio. Disadvantages of DRP i. It has very restrictive assumptions. ii. There is no analytical solution to the DRP program. 2.3 Maximum Diversified Risk (MRD) Portfolio Maximum Diversified Risk Portfolio is a strategy that can be used to calculate the ratio for the most diversified portfolio. This is done using a Diversification Ratio, which shows the relationship between individual and portfolio volatilities.

According to (Choueifaty and Coignard, 2008, 45), the diversification ratio is computed as follows: DI= Where: wi is the portfolio weight σi the volatility of stock I σij the covariance between stocks i and j This diversification index has been used to formulate the Maximum Diversified Ratio formula that can help get the optimum portfolio. It is as shown below: WMDR= Where: 1 is a vector of ones σ is the vector of volatilities Σ is the covariance matrix. Using this formula, one can obtain the optimum portfolio where the risks are diversified fully to get the maximum returns from the portfolio.

The correlations of each instrument to the MDR portfolio are minimized and made equal. This strategy of hedging has various advantages and disadvantages, as follows. The benefit of MDR Portfolio: Since it uses a measure of portfolio diversification, the ratio helps investors obtain improved efficiency compared to other strategies. The disadvantage of MDR Portfolio i. The combination of the correlation of individual instruments exceeds the overall portfolio correlation, hence may be a source of losses. ii. (Choueifaty and Coignard, 2008, 47), acknowledge that the solution of the MDR formula may not be unique, particularly with ill-conditioned covariance matrices. 2.4 Global Minimum Variance (GMV) Portfolio The GMV achieves the least volatility concerning correlations and volatilities.

The Global minimum variance can be calculated as follows: WGMV= Where: 1 is a vector of ones Σ is the covariance matrix. This means that the correlations for individual instruments should exist for the investor to obtain the minimum variance that optimizes the portfolio. However, the primary purpose of GMV is to estimate the lowest risk for an investment opportunity. This strategy has been criticized for: i. Having pronounced concentration in common volatility stocks at the expense of exploiting correlation properties (Amen and Martellini, 2002, 11). ii. Despite the low volatility stocks being attractive or unattractive, using a GMV strategy leads to poorly diversified portfolios and does not use correlations of individual instruments in full. iii. It is also clear that when using this strategy, it is hard to obtain a high-risk diversification in a portfolio compared to other techniques, such as the Maximum Diversified Ratio (Bali and Cakici, 2008, 37).

However, despite several constraints, the GMV is a good strategy for analyzing portfolios. In conclusion, the four systems, that is Equally Weighted (EQW) Portfolio, Diversified Risk Parity (DRP) Portfolio, Maximum Diversification Ratio (MDR) Portfolio, and Global Minimum Variance (GMV) Portfolio, are strategies used in hedging and analyzing the optimality of different portfolios. This varies due to the instruments available for the investor and the risk attitude of the investor.