Friday, April 28, 2017

optimization - How to understand this Risk Parity Algorithm?



I am trying to understand an optimization algorithm to achieve risk parity in a portfolio. I need some help figuring out the notation in the following formula:


Formula, algorithm


I found this on THIS paper.


I understand the following, if you could help me by pointing any mistake, would be great!


I understand that this algorithm is suppossed to iterate the allocation for each asset at a time.




  • $x^*_i$ : The iteration n+1 of asset i.





  • $σ_i$ : The standard deviation of Asset i




  • $x_j$ : allocation for each asset j




  • $\sigma_j$ : The standard deviation of asset j




  • $\rho_{i,j}$ : This is my biggest question. WHAT is this?





  • $b_i$ : The risk budget for the asset, which for risk parity is $\frac{1}{n}$




  • $\sigma(x)$ : The standard deviation of the portfolio




What am I missing?



Answer




Your question seems very simple. The $\rho_{ij}$ are the correlations between asset i and asset j, in other words these are the elements of the correlation matrix. This notation is very standard in portfolio optimization problems. The number of securities n, the n-by-n correlation matrix R and the n vector of $\sigma_j$'s are the main inputs of a risk parity problem.


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