Risk Contribution Is Exposure Times Volatility Times Correlation: Decomposing Risk Using the X-Sigma-Rho Formula

Abstract

Menchero and Davis present a flexible and general framework for attributing portfolio risk to the same decision variables used to attribute portfolio return. For each return source, the authors decompose the risk contribution into a product of exposure, volatility, and correlation. Their method is a generalization of the marginal contribution to risk approach. In addition to providing a highly intuitive risk attribution, the authors’ approach also allows drilldown capability into the volatility and the correlation, thus providing even greater insight into the sources of portfolio risk.

TOPICS: Risk management, portfolio theory, factor-based models