Giuseppe A. Paleologo - Advanced Portfolio Management

Risk models serve four main purposes:

1 Risk Measurement: Estimate the volatility of a portfolio, and from this estimate, the probability of the loss exceeding a certain threshold.

2 Risk Decomposition: The risk comes either from common sources (systematic component) or stock-specific sources.

3 Performance Attribution: Systematic and idiosyncratic sources of returns determine also the performance, and the entire performance of a book through time can be attributed to a combination of both.

4 Hedging: Once the systematic source of risk has been identified, it can be removed without affecting the idiosyncratic sources of return (and risk).

1 1SPY is an ETF closely tracking the SP500 index.

2 2Actually, not that easy. See the notes at the end of this chapter for more details on this topic.

3 3See the surveys by Gabaix [2009], Cont [2001] and references therein.

4 4This does not mean that the average absolute size of returns is 1%; see the FAQ chapter for an explanation.

5 5The Net Market Value, or NMV, is the signed dollar holding value of security held in a portfolio.

6 6This definition makes sense only for assets with a non-zero portfolio NMV, and typically a positive NMV, i.e., for net-long portfolios.

7 7If you want to understand the reason why the idiosyncratic volatility of a diversified, long-only portfolio comprised of many stock is low, you can read the next-to-last question in the Risk FAQ (Section 4.2).

8 8The annualized tracking vol is approximately . The annualization calculation is explained later, in Section 4.2. You can ignore the details of the calculation on a first reading.

9 9In this event, the Prime Broker usually attempts to locate new stocks before forcing covering the position.

10 10The Gross Market Value (GMV) of a stock is the absolute value of the Net Market Value. The GMV of a portfolio is the sum of the GMVs of the individual positions.

11 11A car so well engineered that it managed to be ugly and burst into flames in a low-speed collision.

12 12Famously announced in 1997, it was released in 2011. And it was still an awful game.

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