Risk Parity: The Kryptonite To Alleviate Crypto Market Uncertainty
NOTE: This article was supposed to be published in August of 2021 as part of the medium article series covering Alpha, Beta, Gamma and Parity. But for various reasons, including market and product priorities, the article is being released now with minor changes to reflect the present environment. The article is a gem — full of clear explanations for key concepts in an investment management class you would normally take at an MBA program. Please enjoy.
Quick Update: Starting next week, we will release weekly articles about the team behind the Eiffel Release. We hope to cover all 12 members in the following 3 months.
Bringing Risk Parity To The Defi Party
Plenty of people have made money from investing in DeFi over the past few years — the lending interest, yield farming, liquidity mining, and staking have all generated incredible returns. Though there have been some wild swings, amidst raging turbulence and steep market crashes, the innovation was real and the impact hard to ignore. And, it takes a certain type of person to jump into defi, however. It’s been embraced by the intrepid adventurers, the risk-takers who believe in the whole decentralized philosophy, who have paved the way forward for their peers. Or, to put it another way, the first generation of DeFi hasn’t exactly been for everyone.
Formation Fi is changing that. We are building a simpler way to invest in DeFi that takes away much of the risk while keeping the spectacular gains. The Risk Parity movement has been successfully doing just that in the traditional investing world for many years. We are now leading the way to bring it to multi-chain DeFi.
Balanced Risk Parity: Beating Benchmarks with the Perfect Blend of Contrasting Correlations
Risk Parity is a unique advancement in multi-chain DeFi asset management. The Parity index class is where all our other index classes (Alpha, Beta and Gamma) come together (LINKS to Alpha, Beta, Gamma Articles). In addition to the balanced portfolios created by the other indexes, the Risk Parity strategy provides cover against universal changes such as higher than expected inflation, which could otherwise negatively affect most portfolios, both crypto and traditional.
Risk Parity is an investment movement first pioneered in the All Weather fund by Ray Dalio at Bridgewater Associates in 1996. It aims to return results better than holding cash no matter the circumstances. Many investment managers try to diversify assets but ignore the wider environmental risks, such as inflation or low economic growth that can have a major impact on the entire economy. Some examples of such events are: recessions, the 2008 financial crisis or indeed a global pandemic. It is generally true to a large extent that the wider economic outlook is ‘priced in’ to assets. The risk materializes when expectations aren’t met, in either direction. Risk Parity was designed to enable a portfolio to perform whatever the environment. Until now, this extraordinarily successful mechanism from traditional finance could not be applied to crypto because the tools didn’t exist. But now, Formation Fi is the first to engineer the infrastructure, along with the required foundational principles, to bring such an index to DeFi multi-chain assets.
All major environmental (pan-economy/global) risks can be reduced and classified into one of the boxes in Figure (1). Each box represents one scenario in terms of whether expectations regarding two key drivers, economic growth and inflation, turn out to be lower or higher than expected. The trick is to distribute assets so that whatever box we find ourselves in in the future we will maximize expected returns, at the very least to perform better than cash. To do this, we assign an equal 25% risk allotment to each box since, after all, we cannot predict the future and hence it is hard to know which of the four categories we will end up in. This sameness in terms of the treatment of risk gives the name: Risk Parity. The vision to bring this approach to DeFi, including the design of the overall framework and algorithm, was conceived by the Formation Fi founders in late 2020.
Formation Fi will assign assets to each box so that the amount of risk is the same for each box, whatever the returns from the box corresponding to the relevant market conditions. For instance (Figure 2), the dollar amount granted to Alpha assets will be lower than the appropriation to Gamma since Gamma assets are less risky. Investors can choose a desired level of risk (or equivalent to a target return) and the distribution of their funds to each of the boxes, to create a customized portfolio, will be done by our investment machinery. This personalized portfolio, issued as a Parity index token, will supply returns based upon the specific risk appetite of the investor, no matter the environment.
Though less likely, if growth and inflation meet expectations, that is a good problem to have. In this case, all four quadrants will perform satisfactorily and the combined portfolio will still meet the stated objectives.
While economic growth can be considered a basic environmental factor for traditional assets, growth in the crypto universe can also be linked to two parallel dimensions: trustworthiness and benefits of transacting with a particular cryptocurrency as the medium of exchange. Trustworthiness is heavily dependent on the extent of computing power (or nodes) deployed on a particular platform to verify transactions. The transaction benefits are proportional to the size of the network or the number of active users (wallets) and how well accepted the particular currency is. Our allocation to the four boxes will balance out any fluctuations in the trends of these two key crypto-movers over time.
In conventional investing techniques, selection of assets to balance risks depends on their mutual correlations. Practical experience from managing portfolios shows that correlations are inherently unstable and tend to move to 1 (i.e. perfect correlation) at times of big market-wide stress (e.g. war, natural disaster, socio-political unrest, or market crash). Hence, as our models evolve, our approach to measuring alikeness will use metrics that capture higher dimensions of similarity (and variability) between assets by looking at attributes well beyond risk, return and correlations.
The Parity indexes are composites of the Alpha, Beta and Gamma index classes, weighted so that the risk from each of the four buckets is limited to 25% of the total. The final result is the above individualized matrix of aggregated multi-chain tokens and yield farming strategies. It is algorithmically controlled by smart contracts, regularly rebalancing to keep optimal coverage and maintain the 25% ratio.
The online investing process captures the member’s individual risk appetite (directly or from their DeFi asset manager) and uses it to weigh the multi-chain Alpha, Beta and Gamma assets appropriately. A Parity index token is then minted as an NFT. It is personalized to the member’s needs, representing the best risk-adjusted De-Fi investment in the market. The Parity index token can itself then be staked, exchanged or traded without any limit for further gain.
Leverage: Fortune Favors the Prepared Portfolio
Current views on investing hold many reservations regarding the use of leverage. While excessive leverage can result in losses, a modest amount of leverage, when applied to a small portion of the overall portfolio, has many benefits. In conventional portfolios that are chasing a certain level of return, the majority of the holdings will be concentrated in assets that are closer to the benchmark in terms of their returns. The risk characteristics of these assets are derived from similar sources with the end result being that the overall portfolio will not be well diversified.
A moderate amount of leverage is included in the Parity index class due to the leverage within the Alpha index class. Our Alpha suite will have assets that aim for spectacular returns, but could have risks derived from similar fundamental properties. Hence, to mitigate the concentration risk, we will mix in assets possessing distinctive risk features. These non-identical assets could have lower return profiles, but when they are levered up and combined into the portfolio, they provide an excellent source of diverging movements that offset the overall risk.
This amplification of the returns from chosen assets results in an investment profile that can have lower risk than those of conventional portfolios, which concentrate their holding around assets with similar risk return configurations, providing the same level of returns. The use of leverage in the DeFi world can be seamless due to the high degree of automation. Smart contracts coupled with our algorithms will monitor the level of leverage and automatically trigger events to offset extreme and adverse shifts.
Risk Management Is But Taming The Volatility Skew
The Parity indexes carry a risk level adjusted to the needs of the member. Each Parity index token is personalized and minted with the appropriate weightings of Alpha, Beta and Gamma index class investments.
The most crucial aspect of asset management is to have a rigorous process to calculate risk. Risk is defined and understood in several ways. It is also important to differentiate between risk and uncertainty, which we will explore in subsequent articles. We consider risk as an indicator of the extent of variation in the returns of assets. One of the commonly used metrics as a gauge for risk is the volatility. A particularly popular approach to volatility is computing the standard deviation of returns.
The main issue with minimizing risk using volatility is that volatility is an unobserved variable. This means volatility can only be estimated over historical periods or forecasted over future times since it cannot be directly seen. To mitigate this issue, our models will calculate asset weights based on a range of volatilities rather than trying to pin down one exact volatility number. The additional benefit from this approach will be reduced rebalancing efforts, which will decrease the corresponding blockchain gas costs.
A secondary drawback of volatility is that it fails to capture the effect of changes in the direction of any variable. That is both rising or falling prices are treated equally and hence if we are long a security, upward movements in security prices could get penalized as excess volatility in portfolio management decisions. As an alternative, we devise a metric to measure the path taken by the variable to arrive at the current value, over the last few time periods. To articulate the intuition, any security that had steady upward growth, over a particular time period, is ranked higher than a security with similar growth, over the same time period but with more ups and downs in the path, or changes in direction. Assets are penalized for having ups and downs in their price process. But unidirectional upward jumps suffer no such penalty.
Sharpening the Sharpe Ratio
A key metric used to assess the performance of portfolios is known as the Sharpe ratio (SR). The ratio is the average return (historical or expected) earned on a portfolio in excess of the risk-free rate per unit of volatility or total risk. The widespread use of this metric can be explained due to its simplicity and the powerful insights it provides to investors in understanding how their goals related to risk and return are being met.
An important limitation of the SR is that averages and standard deviations are not enough to completely understand the randomness inherent in the returns generated by any asset. While this limitation is severe enough in traditional portfolios, it is all the more crucial in DeFi. Given the greater volatilities of crypto-assets there are well justified reasons to develop complementary techniques to measure portfolio performance. As a refinement of the SR, we will pay close attention to additional statistical properties called higher moments, also known as Skew and Kurtosis, which show whether there is a greater tendency for either positive or negative movement of returns and whether extreme events are more likely when compared to a normal distribution.
Conclusion: The Formation Fi Revolution For Wealth Gains Without The Pains
Risk Parity investing for cross-chain DeFi is a new development from Formation Fi, the leader in decentralized investments. Members receive a personalized balanced cross chain portfolio constructed algorithmically according to Formation Fi’s Risk Parity strategy. It includes varying measures of Alpha, Beta and Gamma index exposure, risk-adjusted to the requirements of the investor. It is engineered to provide long term high yields protected from market downturns and environmental shocks.
The fundamental doctrine of DeFi is equal access and rights to all participants coupled with complete freedom from any central controlling authority. Bringing this notion of equality to investing is Formation Fi’s core impetus behind initiating the risk parity movement in DeFi. This translates to providing sophisticated asset management techniques, insights and wealth appreciation schemes to all investors. Formation Fi, the trailblazer on this voyage, is doing the needful so that accumulating a Fortune is just a mouse click away from you. Equal Wealth Generation Opportunities are Finally Here.
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