Risk parity allocation - how to find the weight of an asset

CFA Level III
#1

can someone pls help me with the below?

Müller uses a risk parity asset allocation approach with a client’s four–asset class portfolio. The expected return of the domestic bond asset class is the lowest of the asset classes, and the returns of the domestic bond asset class have the lowest covariance with other asset class returns. Müller estimates the weight that should be placed on domestic bonds.

In the risk parity asset allocation approach that Müller uses, the weight that Müller places on domestic bonds should be:

A. less than 25%
B. equal to 25%
C. greater than 25%

I didn’t understand how we got to C.

they have 25% as the portfolio variance which I am not sure why that was used.

#2

Variance/4= weight* cov(bond, market)

If you want to allot same variance component to bond, since covariance is less = give more weight than 25%, to keep the var at 25 for that asset class.

#3

mmmm i didnt understand

#4

In simple terms, since cov is less you will need more than 25% of weight to get to variance of 25%.

In risk parity, each class of asset is allotted similar variance. In this case, there are 4 assets, so each get 25% variance.

1 Like
#5

Risk parity means all asset classes should contribute equally to the portfolio’s variance, so for every asset class w_i X cov (r_p, r_i)=1/n X variance*. Since domestic bonds have the lowest covariance term, this asset class must have higher weights for the relationship to hold.