FRM Part II · FRM Exam Part II · Factor Theory
A risk committee is deciding between allocating capital equally across four factors (value, momentum, carry, low volatility) and a risk-parity allocation across the same factors. Carry has twice the volatility of each other factor, and all pairwise correlations are similar. Relative to equal capital allocation, a risk-parity allocation would most likely:
Risk parity would reduce the weight on carry. Because carry is twice as volatile and correlations are similar, equal capital lets it dominate portfolio risk, so weights are scaled inversely to volatility to equalize each factor's risk contribution.
- ARaise the weight on carry because it has the highest volatility
- BLower the weight on carry so each factor contributes a similar share of portfolio riskCorrect
- CKeep weights unchanged because correlations are similar
- DAllocate only to the factor with the highest expected return
Explanation
Risk parity sets weights roughly inversely proportional to risk contribution, so with similar correlations the higher-volatility factor gets a smaller weight. Equal capital would let carry dominate portfolio risk. Raising the weight on carry does the opposite of equalizing risk.
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