Abstract
This chapter addresses the problem of accurately forecasting and attributing risk in equity portfolios. The chapter develops a hybrid methodology, which takes advantage of the superior forecasting power of implicit factor models while also attributing portfolio risk to economic factors and firm-specific characteristics. The relative accuracy of risk attribution using the hybrid approach versus an explicit cross-sectional factor model is compared in the chapter. However, both of the cross-sectional and two-step hybrid models are rejected by the misspecification. A correct model connecting factor exposures to cross-sectional characteristics is useful. The chapter presents simulation results that the estimation efficiency gained by using the hybrid approach yields substantial improvements over explicit models, given realistic parameter values.
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