Multifactor Risk Models and Heterotic CAPM

TL;DR

This paper provides a comprehensive algorithm and source code for constructing multifactor risk models for equities, integrating style, principal components, and industry factors, with a focus on practical, self-contained methods.

Contribution

It generalizes heterotic risk models to include arbitrary non-industry and industry risk factors, offering a complete, pedagogical approach for risk model construction.

Findings

Provides a complete algorithm and source code for risk models

Introduces a Russian-doll construction for short horizons

Encourages organic risk model building in the investment community

Abstract

We give a complete algorithm and source code for constructing general multifactor risk models (for equities) via any combination of style factors, principal components (betas) and/or industry factors. For short horizons we employ the Russian-doll risk model construction to obtain a nonsingular factor covariance matrix. This generalizes the heterotic risk model construction to include arbitrary non-industry risk factors as well as industry risk factors with generic "weights". The aim of sharing our proprietary know-how with the investment community is to encourage organic risk model building. The presentation is intended to be essentially self-contained and pedagogical. So, stop wasting money and complaining, start building risk models and enjoy!