Multifactor Equity Risk Models and Their Applications
Abstract: Multifactor risk models seek to estimate and characterize the risk of a portfolio, either in absolute value or when compared against a benchmark. Risk is typically decomposed into a systematic and an idiosyncratic component. Systematic risk captures the exposures the portfolio has to broad risk factors. For equity portfolios these are typically countries, industries, fundamental (e.g., size), or technical (e.g., momentum). The portfolio systematic risk depends on its exposure to these risk factors, the volatility of the factors, and how they correlate with each other. Idiosyncratic risk captures the uncertainty associated with news affecting only individual issuers in the portfolio. This risk can be diversified by decreasing the importance of individual issuers in the portfolio. Intuitive multifactor risk models can provide relevant information regarding the major sources of risk in the portfolio. This information can be used to understand the important imbalances of the portfolio and guide the portfolio manager in constructing or rebalancing the portfolio. It can also be used in interpreting results from return attribution or scenario analysis.
Risk management16 is an integral part of the portfolio management process. Risk models ...
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