Chapter 6 - Advanced Risk Budgeting Techniques

Abstract

Risk budgeting techniques assist funds in making trade-off in a rational way. Risk budgeting is an integrated dynamic risk management process that involves risk measurement, risk attribution, and risk allocation. The process gives valuable insight into the hot spots in the portfolio and the clues for improving the risk-adjusted return. There are various strategies with risk budgeting. The strategic asset allocation determines the return and risk of the fund more than any other investment decision; therefore, the allocation requires considerable care and deliberation. Most large institutional investors have future liabilities such as pension payments or life insurance claims, which need to be paid from the fund. Therefore, the strategic asset allocation decision typically involves a trade-off between maximizing the return of the fund and minimizing the likelihood that the value of the investments of the fund drops below the value of the liabilities. Moreover, pension funds and insurance companies also have to deal with the solvency constraints imposed by regulators. The task of finding an appropriate strategic asset allocation policy for institutional investors with liabilities is known as an asset-liability management problem.