Integrated Risk Models
Previous chapters have discussed risk models for individual asset classes such as stocks, bonds, and foreign exchange. This chapter discusses the integration of asset-class risk models into models of aggregate portfolio risk, reaching across asset types and across national borders. The choice of architecture for a multicountry and/or multitype risk model depends crucially on the empirical structure of returns. If the common factors across asset types and countries are nearly the same, then the best architecture is a fully integrated approach. If, on the other hand, the markets are subject to very different factor risks, then a more segmented approach is preferable.
Section 8.1 defines international capital market integration and surveys the empirical evidence on the level and trends in international integration. Section 8.2 presents empirical evidence on integration across asset types. Section 8.3 discusses segmented risk models, in which the risk manager first analyzes the risk of the asset-class allocation and then the active risk of the subportfolio within each asset class. Section 8.4 discusses integrated risk models in which asset-class risk and security-selection risk are analyzed simultaneously.
There are at least three different definitions of international capital market integration. The most fundamental definition relates it to the presence of a common asset pricing model applying across national boundaries. We will call this pricing integration. For simplicity, consider the case of the capital asset pricing model: