APPLICATIONS OF EQUITY RISK MODELS

MultifaCtor equity risk models are employed in various applications such as the quantitative analysis of portfolio risk, hedging unwanted exposures, portfolio construction, scenario analysis, and performance attribution. In this section we discuss and illustrate some of these applications.

Portfolio managers can be divided broadly into indexers (those that measure their returns relative to a benchmark index) and absolute return managers (typically hedge fund managers). In between stand the enhanced indexers, those that are allowed to deviate from the benchmark index in order to express views, presumably leading to superior returns. All are typically subject to a risk budget that prescribes how much risk they are allowed to take to achieve their objectives: minimize transaction costs and match the index return for the pure indexers, maximize the net return for the enhanced indexers, or maximize absolute return for absolute return managers. In all of these cases, the manager has to merge all her views and constraints into a final portfolio.

The investment process of a typical portfolio manager involves several steps. Given the investment universe and objective, the steps usually consist of portfolio construction, risk prediction, and performance evaluation. These steps are iterated throughout the investment cycle over each rebalancing period. The examples in this section are constructed following these steps. In particular, we start with a discussion ...

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