Industry and Country Risk
Estimating country and industry risk factors is of paramount importance in the design and implementation of portfolio risk models. Country and industry allocations are a major determinant of the riskiness of a global equity portfolio, particularly when risk is measured relative to a standard benchmark portfolio. The expansion of the corporate bond market to a wider range of countries has led to an emergent interest in country– industry factors in corporate bond returns.
Country–industry models typically have a very simple structure, with each security having a unit exposure to exactly one industry and one country. Despite their simplicity, these models are surprisingly powerful empirically.
Section 3.1 discusses industry–country factor component models. Section 3.2 examines the relative importance of industry and country factors in explaining equity returns. Section 3.3 discusses industry–country models of corporate bond returns.
Table 3.1 shows the correlation matrix of monthly returns for ten developed market equity indices. Table 3.2 shows the correlation matrix of ten industry indices for U.S. equities. The correlations between U.S. industry portfolios are somewhat higher on average than those between the national indices. The examination of correlation matrices of countrybased indices and industry-based indices is on its own insufficient to evaluate the magnitude of industry and country factors due to the problem of cross-effects. Two country indices could be highly correlated because a large proportion of their index components come from a particular industry; alternatively, two industry portfolios could be correlated because they both have large proportions of stocks from a particular country. To fully understand country and industry risk it is necessary to construct “pure” industry and country factors.