Universal Risk Budgeting

TL;DR

This paper introduces a universal risk budgeting portfolio scheme that weights assets by their performance, allowing incorporation of prior knowledge about asset covariance, and extends universal portfolio theory with novel priors and a new exotic option formulation.

Contribution

It develops a new universal risk budgeting framework with innovative priors and a novel exotic option approach, enhancing flexibility and prior incorporation in portfolio selection.

Findings

Mathematically equivalent to a new universal portfolio with novel priors

Allows incorporation of prior beliefs about covariance structure

Proposes a new exotic option formulation for risk budgeting

Abstract

I juxtapose Cover's vaunted universal portfolio selection algorithm (Cover 1991) with the modern representation (Qian 2016; Roncalli 2013) of a portfolio as a certain allocation of risk among the available assets, rather than a mere allocation of capital. Thus, I define a Universal Risk Budgeting scheme that weights each risk budget (instead of each capital budget) by its historical performance record (a la Cover). I prove that my scheme is mathematically equivalent to a novel type of Cover and Ordentlich 1996 universal portfolio that uses a new family of prior densities that have hitherto not appeared in the literature on universal portfolio theory. I argue that my universal risk budget, so-defined, is a potentially more perspicuous and flexible type of universal portfolio; it allows the algorithmic trader to incorporate, with advantage, his prior knowledge (or beliefs) about the particular covariance structure of instantaneous asset returns. Say, if there is some dispersion in the volatilities of the available assets, then the uniform (or Dirichlet) priors that are standard in the literature will generate a dangerously lopsided prior distribution over the possible risk budgets. In the author's opinion, the proposed "Garivaltis prior" makes for a nice improvement on Cover's timeless expert system (Cover 1991), that is properly agnostic and open (from the very get-go) to different risk budgets. Inspired by Jamshidian 1992, the universal risk budget is formulated as a new kind of exotic option in the continuous time Black and Scholes 1973 market, with all the pleasure, elegance, and convenience that that entails.