International convergence of capital measurement and capital standards for banks

They're back! Post-financialization diversification benefits of commodities

This chapter examines the use and merits of hierarchical clustering techniques in the context of multi-asset multi-factor investing. In particular, it contrasts these techniques with several competing risk-based allocation paradigms, such as 1/N, minimum-variance, standard risk parity and diversified risk parity. The chapter introduces hierarchical risk parity (HRP) strategies based on the Pearson correlation coefficient and also introduces hierarchical clustering based on the lower tail dependence coefficient. The chapter provides an overview of traditional risk-based allocation strategies and outlines a framework to measure and manage portfolio diversification. It examines the performance of the introduced HRP strategies relative to the traditional alternatives. The chapter discusses Meucci's approach to managing diversification, which serves to construct a diversified risk parity strategy based on economic factors.

Hierarchical Risk Parity: Accounting for Tail Dependencies in Multi-asset Multi-factor Allocations

Risk diversification is one of the dominant concerns for portfolio managers. Various portfolio constructions have been proposed to minimize the risk of the portfolio under some constraints, including expected returns. We propose a portfolio construction method that incorporates the complex valued principal component analysis into the risk diversification portfolio construction. The proposed method was verified to outperform the conventional risk parity and risk diversification portfolio constructions.

https://www.mdpi.com/1099-4300/21/2/119/pdf

Complex valued risk diversification

Accurately forecasting the price of oil, the world's most actively traded commodity, is of great importance to both academics and practitioners. We contribute by proposing a functional time series based method to model and forecast oil futures. Our approach boasts a number of theoretical and practical advantages, including effectively exploiting underlying process dynamics missed by classical discrete approaches. We evaluate the finite‐sample performance against established benchmarks using a model confidence set test. A realistic out‐of‐sample exercise provides strong support for the adoption of our approach, which resides in the superior set of models in all considered instances.

/pdf/uncovering-predictability-in-the-evolution-of-the-wti-oil-450bu8m7lj.pdf

Uncovering predictability in the evolution of the WTI oil futures curve

Pursuing risk-based allocation across a universe of commodity assets, we find diversified risk parity (DRP) strategies to provide convincing results. DRP strives for maximum diversification along uncorrelated risk sources. A straightforward way to derive uncorrelated risk sources relies on principal components analysis (PCA). While the ensuing statistical factors can be associated with commodity sector bets, the corresponding DRP strategy entails excessive turnover because of the instability of the PCA factors. We suggest an alternative design of the DRP strategy relative to common commodity risk factors that implicitly allows for a uniform exposure to commodity risk premia.

Maximum diversification strategies along commodity risk factors

Pursuing risk-based allocation across a universe of commodity assets, we find diversified risk parity (DRP) strategies to provide convincing results. DRP strives for maximum diversification along uncorrelated risk sources embedded in the underlying commodities. A straight-forward way to derive uncorrelated risk sources relies on principal components analysis (PCA). While the ensuing statistical factors can be associated with commodity sector bets, the corresponding DRP strategy entails excessive turnover because of the instability of the PCA factors. As an alternative, one may run the DRP strategy relative to common commodity risk factors that have been orthogonalized such that they exhibit a minimum tracking error to the original factors. The DRP strategy then builds on a more stable anchor that implicitly allows for a uniform exposure to commodity risk premia.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2894990_code694027.pdf?abstractid=2290776&mirid=1&type=2

Maximum Diversification Strategies Along Commodity Risk Factors

The Basel Committee plans to revise the Standardised Approach (SA) to bank capital for credit risk and to employ the revised SA as a floor for bank capital based on internal models. The changes are likely to have a major impact on the overall level of capi tal and its distribution across banks and asset classes. This paper examines the effects of the proposed changes in capital rules on the Swiss loan market. Using primarily public information, we estimate the effects on the capital of individual Swiss banks broken down by asset class. We infer what this is likely to imply for lending rates in the Swiss market. We find that the proposed rule changes would substantially boost capital overall, affecting most severely capital for Corporate and Specialised L endin g exposures. Under the BCBS 347 proposals, total bank capital would rise 39% while capital for Corporate and Specialised Lending exposures would increase by 142% and 130%, respectively. This allocation of capital across asset classes is inconsistent with t he lessons of the recent financial crisis which was triggered by the collapse of the US residential mortgage market and involved relatively little impact on the quality of corporate credit . By our calculations, bank spreads for corporate loans would rise b y between 6 3 and 10 3 basis points.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2617670_code2069380.pdf?abstractid=2615748

Capital Floors, the Revised SA and the Cost of Loans in Swi tzerland

The concept of second-order risk operationalizes the estimation risk in portfolio construction induced by model uncertainty. We study its contribution to the realized volatility of recently developed risk parity strategies. For each strategy, we derive closed-form solutions for the second-order risk, subsequently illustrated in empirical analysis based on real market data. The results suggest a relation between the contribution of second-order risk and the sensitivity of a portfolio to single eigenvectors of the covariance matrix of assets' returns. Among the strategies considered, we find the principal risk parity strategy, that invests equally in each eigenvector underlying the variance-covariance matrix, to be immune to second-order risk. For the other strategies, second-order risk can be partially mitigated by means of statistical methods.

https://www.zora.uzh.ch/id/eprint/171147/1/SSRN-id3090624.pdf

Simone Bernardi

Papers

Maximum diversification strategies along commodity risk factors

Maximum Diversification Strategies Along Commodity Risk Factors

Capital Floors, the Revised SA and the Cost of Loans in Swi tzerland

Second-Order Risk of Alternative Risk Parity Strategies