Custom v. Standardized Risk Models
Abstract
We discuss when and why custom multi-factor risk models are warranted and give source code for computing some risk factors. Pension/mutual funds do not require customization but standardization. However, using standardized risk models in quant trading with much shorter holding horizons is suboptimal: 1) longer horizon risk factors (value, growth, etc.) increase noise trades and trading costs; 2) arbitrary risk factors can neutralize alpha; 3) "standardized" industries are artificial and insufficiently granular; 4) normalization of style risk factors is lost for the trading universe; 5) diversifying risk models lowers P&L correlations, reduces turnover and market impact, and increases capacity. We discuss various aspects of custom risk model building.
Cite
@article{arxiv.1409.2575,
title = {Custom v. Standardized Risk Models},
author = {Zura Kakushadze and Jim Kyung-Soo Liew},
journal= {arXiv preprint arXiv:1409.2575},
year = {2015}
}
Comments
30 pages; minor improvements, more source code added; to appear in Risks