Risk Parity, Diversification, and Factors

Under development

This lesson is part of the course scaffold and is being actively written. The learning objectives and outline below define its final scope.

Learning objectives

By the end of this lesson you will be able to:

• Quantify portfolio diversification benefit as a function of pairwise correlation and strategy count, and compute the effective number of independent bets in a book
• Construct an equal-risk-contribution (risk parity) portfolio and compare its properties against equal-weight and mean-variance allocations
• Measure a trading strategy's exposures to canonical factors (market, value, momentum, carry) by regression and interpret the residual as evidence for or against genuine alpha
• Evaluate whether a candidate strategy adds diversification to an existing book using correlation structure and factor overlap

Outline

1. The diversification math — why correlation, not strategy count, is the whole game
2. Effective number of bets — from N strategies to truly independent risk
3. Risk parity — equal risk contribution, construction, and the leverage it implies
4. Critiques of risk parity — crowding, rate regimes, hidden factor bets
5. Factor investing — the canonical factors, their premia, and their drawdowns
6. Factor exposures of trading strategies — regression-based attribution
7. Admitting a new strategy — correlation and factor-overlap gates for the book

Prerequisites

• Risk Measurement