Handbook of Finance: Investment Management and Financial Management

Chapter 31. Fundamental Multifactor Equity Risk Models

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

RAMAN VARDHARAJ, CFA

Senior Quantitative Analyst, RS Investments

FRANK J. JONES, PhD

Professor of Finance, San Jose State University

Abstract: Multi-factor equity risk models are classified as statistical models, macroeconomic models, and fundamental models. The most popular type of model used in practice is fundamental models. Many of the inputs used in a multi-factor risk model are those used in traditional fundamental analysis. There are several commercially available fundamental multi-factor risk models. There are investment management companies that develop proprietary models. Brokerage firms have developed models that they make available to institutional clients.

Keywords: multifactor equity risk models, fundamental models, return-generating function, risk factors, descriptors, risk indices, risk decomposition, total excess return, total excess risk, common factor risks, specific risk, residual risk

Quantitative-oriented common stock portfolio managers typically employ a multi-factor equity risk model in constructing and rebalancing a portfolio and then for evaluating performance. The most popular type of multi-factor equity risk model used is a fundamental factor model. While some asset management firms develop their own model, most use commercially available models. In this chapter we use one commercially available model to illustrate ...