Equity Valuation and Portfolio Management

CHAPTER 13

Multifactor Equity Risk Models and Their Applications^*

Anthony Lazanas, Ph.D.

Managing Director Barclays Capital

António Baldaque da Silva, Ph.D.

Director Barclays Capital

Arne D. Staal, Ph.D.

Director Barclays Capital

Cenk Ural, Ph.D.

Vice President Barclays Capital

Risk management is an integral part of the portfolio management process. Risk models are central to this practice, allowing managers to quantify and analyze the risk embedded in their portfolios. Risk models provide managers insight into the major sources of risk in a portfolio, helping them to control their exposures and understand the contributions of different portfolio components to total risk. They help portfolio managers in their decision-making process by providing answers to important questions such as: How does my small-cap exposure affect portfolio risk? Does my underweight in diversified financials hedge my overweight in banks? Risk models are also widely used in various other areas such as in portfolio construction, performance attribution, and scenario analysis.

In this chapter, we discuss the structure of multifactor equity risk models, types of factors used in these models, and describe certain estimation techniques. We also illustrate the use of equity risk factor models in various applications, namely the analysis of portfolio risk, portfolio construction, scenario analysis, and performance attribution.

Throughout this chapter, we will be using the Barclays Capital Global Risk Model¹ for ...