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
Date Written: January 24, 2016
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: Suggested Citation