Portfolio Risk Analysis

By Gregory Connor; Lisa Goldberg et al. | Go to book overview

6
Security Characteristics and
Pervasive Risk Factors

Observable characteristics of equities—such as market capitalization, book-to-price ratio and other accounting ratios, and return-based characteristics such as momentum and volatility—have surprisingly strong power in explaining the comovements of individual equity returns. Similarly (but less surprisingly), cash flow and credit characteristics explain the comovements of individual bonds. This chapter explores the empirical link between security characteristics and return comovements and discusses how best to incorporate them into portfolio risk analysis models. Section 6.1 discusses some of the stock and bond market characteristics with empirical links to return comovements. Section 6.2 introduces Rosenberg's approach to factor modeling of security returns, in which suitably normalized security characteristics serve as factor exposures. Section 6.3 examines the Fama–French factor model of stock and bond returns, a time-series regression-based alternative to Rosenberg's model. Section 6.4 considers semiparametric characteristic-based factor models, which combine elements of the Rosenberg and Fama–French approaches.


6.1 Equity and Fixed-Income Characteristics

6.1.1 Characteristics of Default-Free Fixed-Income Securities

The dominant source of risk for a default-free fixed-income security is changes in the term structure of interest rates. As a consequence, characteristic-based risk measures for default-free fixed-income securities rely on models of term-structure shocks.


6.1.1.1 Term-Structure Shocks

The term structure of interest rates is defined as the set of long rates y = (y1, y2, …, yT), where yτ is the internal rate of return1 on a

1 The internal rate of return is the constant interest rate that sets the present value of
future cash flows equal to the current price of the bond.

-117-

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Portfolio Risk Analysis
Table of contents

Table of contents

  • Title Page iii
  • Contents vii
  • Acknowledgments xi
  • Introduction xiii
  • Key Notation xix
  • 1: Measures of Risk and Return 1
  • 2: Unstructured Covariance Matrices 36
  • 3: Industry and Country Risk 61
  • 4: Statistical Factor Analysis 79
  • 5: The Macroeconomy and Portfolio Risk 101
  • 6: Security Characteristics and Pervasive Risk Factors 117
  • 7: Measuring and Hedging Foreign Exchange Risk 134
  • 8: Integrated Risk Models 155
  • 9: Dynamic Volatilities and Correlations 167
  • 10: Portfolio Return Distributions 191
  • 11: Credit Risk 212
  • 12: Transaction Costs and Liquidity Risk 241
  • 13: Alternative Asset Classes 271
  • 14: Performance Measurement 299
  • 15: Conclusion 319
  • References 323
  • Index 345
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