Custom v. Standardized Risk Models
Risks 3(2) (2015) 112-138
30 Pages Posted: 9 Sep 2014 Last revised: 21 May 2015
Date Written: May 7, 2015
We discuss when and why custom multi-factor risk models are warranted and give source code for computing some risk factors. Pension/mutual funds do not require customization but standardization. However, using standardized risk models in quant trading with much shorter holding horizons is suboptimal: 1) longer horizon risk factors (value, growth, etc.) increase noise trades and trading costs; 2) arbitrary risk factors can neutralize alpha; 3) "standardized" industries are artificial and insufficiently granular; 4) normalization of style risk factors is lost for the trading universe; 5) diversifying risk models lowers P&L correlations, reduces turnover and market impact, and increases capacity. We discuss various aspects of custom risk model building.
Keywords: Risk model, multi-factor, risk factor, short horizon, quant trading, style, industry, specific risk, factor risk, alpha, portfolio optimization, regression
JEL Classification: G00
Suggested Citation: Suggested Citation