Equity Valuation and Portfolio Management

EQUITY RISK FACTOR MODELS

The design of a linear factor model usually starts with the identification of the major sources of risk embedded in the portfolios of interest. For an equity portfolio manager who invests in various markets across the globe, the major sources of risk are typically country, industry membership, and other fundamental or technical exposures such as size, value, and momentum. The relative significance of these components varies across different regions. For instance, for regional equity risk models in developed markets, industry factors tend to be more important than country factors, although in periods of financial distress country factors become more significant. On the other hand, for emerging markets models the country factor is still considered to be the most important source of risk. For regional models, the relative significance of industry factors depends on the level of financial integration across different local markets in that region. The importance of these factors is also time-varying, depending on the particular time period of the analysis. For instance, country risk used to be a large component of total risk for European equity portfolios. However, country factors have been losing their significance in this context due to financial integration in the region as a result of the European Union and a common currency, the euro. This is particularly true for larger European countries. Similarly, the relative importance of industry factors is higher ...