Definition
Hierarchical Risk Parity (HRP) is a portfolio construction method that addresses the limitations of traditional mean-variance optimization by incorporating correlation structures. It utilizes hierarchical clustering algorithms to group assets based on their similarity, then allocates capital recursively through the dendrogram structure. This approach ensures diversification by treating clusters as distinct units, reducing sensitivity to estimation errors in covariance matrices and providing more robust out-of-sample performance compared to classical methods.
Summary
A portfolio optimization technique that uses clustering to handle asset correlation and allocates risk across hierarchical clusters.
Key Concepts
- Clustering
- Dendrogram
- Risk Allocation
- Covariance Matrix
Use Cases
- Portfolio management
- Asset allocation
- Risk mitigation