Investment Risk and Uncertainty: Advanced Risk Awareness Techniques for the Intelligent Investor

CHAPTER 1

Exposed versus Experienced Risk Revisited

Steven P. Greiner, PhD, and Andrew Geer, CFA, FRM

If you ask five different investment professionals what the term exposure means to them, you’ll probably get five similar, yet distinctively unique, answers. For instance, when equity portfolio managers (PMs) are discussing currency risks, they will interchangeably confuse the word exposure with position size in some denominated currency. Likewise, active investment management professionals often refer to a portfolio’s active weight in an industry, like information technology (IT), to be its exposure to that industry. Neither of these is a correct interpretation of the term. In a nebulous sense, exposure simply represents a contribution to future portfolio risk from some source, and that’s how it’s mostly interpreted. In a strict sense, it represents a measurable characteristic to the portfolio such as style, industry, currency, or country association. It more exactly represents a value that, when multiplied by the portfolio’s beta to the factor, yields the factor’s contribution to return. This is, of course, for risk models predicated on the (somewhat) standardized methodology of using cross-sectional regressions of return for a given time period. Exposures are the actualization of stock-specific or stock-dependent values in this sense. For instance, if a risk model contains the price-to-book (P/B) ratio as a factor, exposure is a stock’s P/B. If the risk model contains stock ...