Continous Risk Adjustment - Does the Half-Life have

Implications for the Return Distribution

Linus Nilsson
Whitepaper - Nordic Hedge

Abstract

Risk Parity, Quantitative Trading strategies and Volatility Managed portfolios

scales positions inversely to estimates of volatility. We study the impact of
continuous risk adjustment for a set of Futures markets.
The shorter the half-life of a risk adjustment strategy is, the more normal our
returns look like using a standard test for normality. Returns are still non-
normally distributed, but for financial markets a continuous risk-adjustment
process manages to create a more well behaved distribution.
The result has important impact for so called risk-parity portfolios that are thus
not automatically riskier due to various optimization techniques and leverage,
at least in the absence of heterogeneous methods to estimate and manage risk.
Keywords: Risk Parity, Volatility, Volatility Adjustments, Portfolio
Construction, Volatility Estimation
JEL classification: G01

Email address: linus@nordichedge.com (Linus Nilsson)

Electronic copy available at: https://ssrn.com/abstract=2667156

Introduction

In electrical engineering, statistics and finance adjusting the signal to noise

is of paramount importance. Within the Risk Parity (RP) portfolio framework,
estimating risk is one of the crucial components. There is a rather large academic
industry that is occupied with creating different types of risk models.
While it may be too obvious to state, risk estimation for real portfolios, can
only be based on data known up to the point of estimation. That is, you cannot
have a model that includes the Flash Crash or Black Monday before they have
taken place. What you do not know today, you cannot have known yesterday.
There are several papers that are using future information, incorporated
into the results. For instance [1], provide a well written paper that provides
convincing evidence for the risk parity approach but does suffer from a look-
ahead bias in terms of risk estimates.
In this paper, we will explore what happens if we vary the amount of history
that we incorporate into the risk estimate. We will pick one risk measure, a
slightly modified Average True Range (ATR) that is both popular within the
trading community. ATR has only one parameter, the half-life of information
and does also incorporate the range of the day, adjusted for gaps. ATR was first
published in [2] and as with most measure during the era of low computer avail-
ability it was based on an exponential weighting scheme to reduce the number
of calculation. It does also contain range information that was explored in for
instance [3] that is more common in the academic world.
The ATR was not the first measure to include range-based measures of
volatility, but it is one of the more popular ones in the trading literature.

ATR definition and modifications

The ATR is a rather straight forward, an exponentially moving average

incorporating the High (H), Low (L) and the previous Close (C) of a trading
day.

Electronic copy available at: https://ssrn.com/abstract=2667156

 Having been developed in the era where trading was discontinuous and was
dominated by the discrete pit-trading hours the importance of adjusting risk-
measure for overnight gaps carried weight. The ATR is defined as:

AT Rt−1 (n − 1) + T Rt
AT Rt = (1)
n

Where
T Rt = max(Ht − Lt , |Ht − Ct−1 |, |Lt − Ct−1 |) (2)

As seen, the ATR has one free parameter, the number of days (n). The
parameter is equivalent to the decay function in an Exponentially Weighted
Moving Average (EWMA) if it is transformed as:

1
λ=1− (3)
n
Estimating risk with EWMA is for instance used by RiskMetrics and is
fairly common. Since the ATR is not dimensionless (measured as a price), it
is advisable to divide the ATR by the current price to obtain a dimensionless
measure. This will make the risk-measure compatible with return-based metrics
and insensitive to the current price.
As a sidenote, we will require a history of 2n, to allow for calibration of the
risk measure. An alternative methods would be to define the first value as the
simple average of the first n observations.
Compared to a EWMA, the ATR will give slightly different measures of
risk. On average, the ATR is larger than the EWMA, but is not strictly larger
(Figure 1). It depends on which decay that is being used. For extreme moves,
the ATR tends to record a larger value, but both measures are path dependent
and will depend on how much prior history that is included. For high resolution
data, in the limit, these two measures will converge.
The proportion between ATR and EWMA standard deviation will depend on
the market structure itself and intraday momentum structure. The measure will
deviate more if a larger number of return observations exhibit low close-to-close
volatility while at the same time exhibiting large ranges.

Electronic copy available at: https://ssrn.com/abstract=2667156

 0.02

0.02

0.02

0.02
20-day EWMA

0.02

0.01

0.01

0.01

0.01

0.01
0.01

0.02

0.02

0.03

0.03

0.04
20-day ATR

Figure 1: Daily ATR compared to EWMA Standard Deviation (S&P 500, from Sep 97 to Sep
15). Color indicate magnitude of volatility

Over the complete sample, the two measures are largely correlated, but is
market dependent as seen in Figure 2. Over most markets, the ATR is between
1.2 and 1.7 times larger than the EWMA. This is as expected as the gap-
adjusted high-low range is at least as large as the close-to-close volatility. How
much larger, is dependent on the market sample itself.
The purpose of the section is to establish that two common estimators of
(historic) volatility are highly correlated. Figure 2 displays correlations between
an EWMA and an ATR, with the same parameters for a set of market segments.

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 Correlation between ATR (n-day) EWMA (n-day)
0.99

0.98

0.97

0.96

0.95

0.94

0.93

0.92 S&P500
US 10 year Treasury
0.91 Gold
Crude Oil
0.9
0

50

100

150

200

250
Half Life (days)

Figure 2: Correlation between ATR and EWMA volatility estimation for four global markets.
We note that the measures are highly correlated for some typical markets. We would probably
see similar divergences between other risk measures as price based measures are correlated
over time.

Risk Adjustment

As we previously mentioned, adjusting the signal to noise is common in most

signal driven investment processes. We decide to adjust the signal (position) S
as follows:

Ŝ
S= (4)
σ2
Ŝ is the raw signal and σ 2 is a risk estimate. This is one of fundamental
equations for risk parity (or more strictly speaking, volatility parity) portfolios.
Each signal is adjusted for its own volatility and in the absence of correlation,

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the risk contribution to the portfolio will be equal. There are more advanced
ways to compose risk-parity portfolio, using for instance correlation or more
advanced estimators of risk. This is however outside the scope of this paper.
With the risk of repeating ourselves, the volatility needs to be known be-
fore the adjustment is taking place. As an example, we will be comparing an
investment into the S&P 500 Index, unadjusted as well as volatility adjusted.

0.01

0.009
Unadjusted Returns

0.008

0.007

0.006

0.005
0.01

0.01

0.02

0.02

0.03

0.03

0.04

0.04

0.05

0.05

0.06

ATR Adjusted Returns

Figure 3: S&P 500 realized volatility for adjusted and unadjusted investments.

In Figure 3, we note that the volatility of an adjusted time series is more

constant that for an unadjusted. For this example, using a 20-day exponential
ATR we manage to compress the volatility range (maximum volatility compared
to minimum volatility) by a factor of 5.
For this market, the Sharpe of raw and risk adjusted returns are approxi-
mately the same. However, with risk adjustments, we have created something

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that is more stable in terms of volatility distribution.
Observing the Q-Q plot in Figure 4, we note that while the worst returns
are of the same magnitude, risk adjusted returns seem to be more on a straight
line. This may indicate that the risk adjusted returns are closer to a normal
distribution. For this example, the R2 increases from 0.88 to 0.98 to the normal
distribution.
An ocular inspection of, shows that the belly of the distribution is more
normal. That said, we still have rather larger outliers, especially so on the
downside. As noted previously, sudden negative or positive surprises cannot
be known in advance and will therefore have a large impact. RP portfolios
will typically reduce the position after a risk increase making them potentially
sensitive to rapid bounce-backs in the market. For markets where expanding
volatility indicates negative drift, RP strategies will generally perform better.

Data length and normality

Next, we will perform a large-scale experiment, using a set of mainly US

future markets with varying lookbacks, representing daily risk estimates ranging
from one week to 64 weeks in “binary steps” (1,2,4,8,16,32 and 64 weeks). We
will adjust the signal to the noise as described in the prior section. We will test
the different results for normality using a Shapiro-Wilk normality test. A useful
review of other normality test statistics is discussed in [4]. The Shapiro-Wilk
test is defined as follows:
Pn
( i=1 ai yi )2
W = n
P 2
(5)
i=1 (yi − ŷ)

Where:
mT V −1
ai = √ (6)
mT V −1 V −1 m
And yi is the ith order statistic, ŷ is the sample mean and m = (mt , ..., mn )T
are the expected value of the order statistics of independent and identically
distributed random variables samples from the standard normal distribution.
V is the co-variance matrix of those order statistics. From a computational

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perspective, we will be using Royston’s algorithm, which is suitable for n up to
5000[5].
Data Quantiles

Raw Returns
Risk Adjusted
−4

−3

−2

−1

Theoretical Quantile 4

Figure 4: Q-Q Plot for S&P 500, unadjusted return and risk adjusted return. We note that
the adjusted return series exhibit a slightly more normal profile. Here, it can be noted that
the largest increases in equity markets seems to take place under volatile conditions, when the
risk adjustment strategy has reduced exposure.

Given Figure 4 above, we expect to reject normality for both the risk adjusted
and raw return series. We are primarily interested to find out by how much we
can potentially improve returns.

Results

We compute the Shapiro-Wilk’s z-score for a large set of liquid futures mar-
kets. Any tested length of the risk adjustment will not create a return distri-
bution that can be characterized as normal. However, we manage to make the

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return distribution more normal across most sectors. The exception is precious
metals where the returns are less normal for the slower adjustment horizons.
The longer the horizon, over which we estimate the risk, the small the im-
provement between the normality score for adjusted and non-adjusted returns
are. The largest improvements, seem to take place at horizons between two
and four weeks. In this area, we observe the most improvements in terms of
normalization of the returns.

1.8
Bond
Improvement over Non-Risked Adjusted Returns

1.7 Commodity
Energy
1.6 Equity
Precious Metal
1.5 Currency
Average
1.4

1.3

1.2

1.1

0.9
0

10

20

30

40

50

60

70

Half-life of Risk Estimate (Weekly)

Figure 5: Ratio between risk adjusted and non-risk adjusted returns, using SW test for nor-
mality.In general, the shorter the time horizon, the better the risk adjustment process works.

Figure 5 and Table 1 shows the improvement in Sharpe-Wilks z-score, per

horizon, grouped by Commodities (Energy, Precious Metals and other Com-
modities) and Financials (Stock Indices, Fixed Income and Currencies).
Any adjustment will impose transactions costs, but investors seeking to de-

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Table 1: Changes in normality score when risk adjusting over various time horizons. Improve-
ment in Sharpe-Wilks z-score, per horizon, grouped by Commodities (Energy, Precious Metals
and other Commodities) and Financials (Stock Indices, Fixed Income and Currencies).

Horizon
Commodities Financials
(Weeks)

1 1.29 1.60
2 1.32 1.66
4 1.35 1.63
8 1.33 1.56
16 1.23 1.47
32 1.15 1.32
64 1.14 1.20

liver less non-normally distributed returns, shorter term risk adjustments will
get returns that are somewhat closer to normally distributed using a short-term
noise adjustment procedure.

Conclusion

We have noted that adjusting a signal to the short term noise results in a
return distribution that looks to be closer to a normal distribution. This has
potentially important implications on portfolio optimization strategies that are
not adjusted for higher moments. Adjusting the position, inversely proportional
to the volatility will result in returns that are distributionally friendlier (e.g.
more normally distributed).
As with most results in finance, the risk adjustment does not come for free,
but will impose transaction costs as positions are adjusted. A portfolio would
also have to accept leveraged as positions will be leveraged up when the noise
is low.
If everyone would adjust their positions according to the contemporary noise
in the market, this may trigger forced de-leveraging. In general, although not

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discussed in this text, adjusting for risk, will reduce sensitivity to prolonged
volatility periods while it will increase sensitivity to short term bursts of volatil-
ity.

References

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[3] M. B. Garman, M. J. Klass, On the estimation of security price volatilities

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[4] B. W. Yap, C. H. Sim, Comparisons of various types of normality tests,

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[5] P. Royston, Remark as r94: A remark on algorithm as 181: The w-test

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