10 January 2014, BNP Paribas Asset Management, 14 rue Bergre, 75009 Paris, France
We show that there is not just one, but several effects explaining the increased Sharpe ratio in portfolios managed to target inter-temporal risk parity and to discuss their relative importance. Volatility clustering and the negative correlation between volatility and returns are the two most important factors. In a world of normal distributed returns, where volatility is constant and thus the strategy is obsolete, we show that before transaction costs, the strategy does not destroy value with Sharpe ratio and drawdowns similar to those from a buy and hold strategy.
In the second part of the paper we look at actual historical asset class return distributions. We discuss the problem of forecasting volatility which, as discussed by Hallerbach [2012], should also be of great importance. We find that short-term volatility models with neither assumptions for the long-term average volatility level, nor regime switching, appear to achieve a superior control of volatility expost
and the most successful smoothing of risk as well as the larger improvement in the Sharpe ratio.
In particular, we show the superiority of the I-GARCH model in forecasting equity volatility and
control for volatility ex-post.
Using I-GARCH models, we show that the application of an inter-temporal risk parity strategy for
equities does result in an improvement in the Sharpe ratio and reduction in portfolio drawdowns. The
results are better for emerging equities than for developed equities. When applying the strategy to
other asset classes we also find a large improvement in the Sharpe ratio of high yield corporate bonds.
However the improvement of the Sharpe ratio is less evident for commodities, investment grade
corporate bonds or government bonds.
what is the Relationship between returns and volatility regimes ?
:faint:
I am not able to understand it.Can anyone explain?