FRM Part II · FRM Exam Part II · Portfolio Construction
A risk parity fund holds equities and bonds sized so each contributes equally to risk. Bond volatility is only 4% versus equity volatility of 16%, with a modest positive correlation. To reach a target portfolio volatility of 10%, which is above what the unlevered mix would deliver, what action is required, and what key risk does it introduce?
The manager should lever the entire risk-balanced portfolio up to the target volatility, preserving equal risk contributions. This introduces funding-cost risk and the danger of forced deleveraging if bonds and equities fall together, such as in a sharp rise in yields.
- AIncrease equity weight only; this adds concentration risk in equities
- BApply leverage to the whole risk-balanced portfolio; this adds funding and deleveraging risk if bond yields rise sharplyCorrect
- CHold cash instead; this adds reinvestment risk
- DShort bonds; this adds negative carry only with no other risk
Explanation
A risk-balanced portfolio is dominated by low-volatility bonds, so unlevered volatility is below target. Leverage scales the entire portfolio while preserving risk balance. The cost is funding cost and the risk of forced deleveraging when bonds and equities fall together, for instance in rising rate shocks. Raising equities only breaks the risk parity balance.
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