Handbook of Market Risk

Chapter Six

Market Risk and Fundamental Multifactors Model

It's impossible that the improbable will never happen.

—Emil Gumbel

This chapter is a reproduction of the risk model handbook published in June 2011 by Axioma^TM1. The Factors model is an important method for measuring market risk and therefore we believed it was convenient to introduce the readers to the technics and process when building and developing a fundamental equity model.

What is risk and what is the best way to measure it? There is no single answer to the question, What is the volatility of a given asset or portfolio? Economists, for example, typically associate risk with abstract notions of individual preference, whereas financial regulators may prefer a measure such as value-at-risk (VaR). Axioma defines risk as the standard deviation of an asset's return over time. This statistical definition is straightforward, broadly applicable, and intuitive. An asset whose return varies wildly over time is volatile and therefore risky; another whose return remains fairly constant is relatively predictable, and thus less risky.

Throughout the following discussion, r_i,t will represent the return to an asset i, at time t:

where p_i,t is the asset's price at time t, d_i,t is any dividend payout at time t, and p_i,t−1 is the price at the previous time period, adjusted for any corporate actions (e.g., stock splits). The time increment ...