Advanced Idiosyncratic Risk and Multi-Factor Models – Short Version

Abstract

We introduce advanced idiosyncratic risk (“AI-Risk”), a parsimonious correlated residual correction to a predictive stress CAPM-like factor model, aimed to get more accurate stock-stock correlations. We find that AI-Risk can be significant for stock portfolios. Inclusion of AI-Risk gives a more realistic risk assessment, consistent with real-world correlation constraints. We also indicate the generalization of AI-Risk to cross-sectional regression factor models, of interest to PMs. This paper is an abridged version.

Keywords: AI-Risk, correlated residuals, accurate correlations, cross-section regression, factor models

JEL Classification: C1, C14, C22, C63, F65, G1, Y1