Multifactor Risk Models and Heterotic CAPM

The Journal of Investment Strategies 5(4) (2016) 1-49

49 Pages Posted: 26 Jan 2016 Last revised: 10 Sep 2016

See all articles by Zura Kakushadze

Zura Kakushadze

Quantigic Solutions LLC; Free University of Tbilisi

Willie Yu

Duke-NUS Medical School - Centre for Computational Biology

Date Written: January 24, 2016

Abstract

We give a complete algorithm and source code for constructing general multifactor risk models (for equities) via any combination of style factors, principal components (betas) and/or industry factors. For short horizons we employ the Russian-doll risk model construction to obtain a nonsingular factor covariance matrix. This generalizes the heterotic risk model construction to include arbitrary non-industry risk factors as well as industry risk factors with generic "weights". The aim of sharing our proprietary know-how with the investment community is to encourage organic risk model building. The presentation is intended to be essentially self-contained and pedagogical. So, stop wasting money and complaining, start building risk models and enjoy!

Keywords: multi-factor risk model, risk factors, optimization, regression, specific risk, factor risk, mean-reversion, covariance matrix, correlation matrix, factor loadings, dollar neutrality, style factors, industry factors, principal components

JEL Classification: G00

Suggested Citation

Kakushadze, Zura and Yu, Willie, Multifactor Risk Models and Heterotic CAPM (January 24, 2016). The Journal of Investment Strategies 5(4) (2016) 1-49. Available at SSRN: https://ssrn.com/abstract=2722093 or http://dx.doi.org/10.2139/ssrn.2722093

Zura Kakushadze (Contact Author)

Quantigic Solutions LLC ( email )

1127 High Ridge Road #135
Stamford, CT 06905
United States
6462210440 (Phone)
6467923264 (Fax)

HOME PAGE: http://www.linkedin.com/in/zurakakushadze

Free University of Tbilisi ( email )

Business School and School of Physics
240, David Agmashenebeli Alley
Tbilisi, 0159
Georgia

Willie Yu

Duke-NUS Medical School - Centre for Computational Biology ( email )

8 College Road
Singapore, 169857
Singapore

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