On the financial interpretation of risk contributions: an analysis using Quantile Simulation

Abstract

This paper tests whether the financial interpretation of risk contributions (Qian, 2006), as measured by marginal change in volatility, holds when accounting for fat tails in the asset return distributions. This important result is the theoretical foundation of risk-based portfolios, but relies on the assumption of normality. If the result does not hold, more sophisticated techniques are required to estimate risk-based portfolios.

A simulation study is conducted to replicate the stressed environment required by Qian (2006). The Quantile Simulation method (Alexander, 2013) is used to simulate asset return distributions that are reasonable replicates of the empirical samples. Given the relative novelty of the simulation method, this paper also reports the extent to which the simulated samples can approximate the empirical sample of each asset