Abstract
Multifactor risk models seek to estimate and characterize the risk of a portfolio, either in absolute value or when compared against a benchmark. Risk is typically decomposed into a systematic and an idiosyncratic component. Systematic risk captures the exposures the portfolio has to broad risk factors, such as interest rates or spreads. This risk is driven by the exposure of the portfolio to these risk factors, their volatility, and the correlation between these different sources of risk. Idiosyncratic risk captures the uncertainty associated with the particular issuers in the portfolio. Idiosyncratic risk is diversifiable by spreading the exposure to a large number of individual issuers. Multifactor risk models allow for the decomposition of the total risk by risk factor (or sets of risk factors). If the factors are economically meaningful, the risk model can provide relevant intuition regarding the major variables influencing the volatility of the portfolio and be a useful tool in portfolio construction. Keywords: Risk models; risk factors; tracking error volatility; risk report; portfolio construction; contributions; risk budgeting; covariance matrix
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