barra_handbook_US

UnitedStatesEquityVersion3(E3)RISKMODELHANDBOOKBARRAmakesnowarranty,expressorimplied,regardingtheUnitedStatesEquityRiskModeloranyresultstobeobtainedfromtheuseoftheUnitedStatesEquityRiskModel.BARRAEXPRESSLYDISCLAIMSALLWARRANTIES,EXPRESSORIMPLIED,REGARDINGTHEUNITEDSTATESEQUITYRISKMODEL,INCLUDINGBUTNOTLIMITEDTOALLIMPLIEDWARRANTIESOFMERCHANTABILITYANDFITNESSFORAPARTICULARPURPOSEORUSEORTHEIREQUIVALENTSUNDERTHELAWSOFANYJURISDICTION.AlthoughBARRAintendstoobtaininformationanddatafromsourcesitconsiderstobereasonablyreliable,theaccuracyandcompletenessofsuchinformationanddataarenotguaranteedandBARRAwillnotbesubjecttoliabilityforanyerrorsoromissionstherein.Accordingly,suchinformationanddata,theUnitedStatesEquityRiskModel,andtheiroutputarenotwarrantedtobefreefromerror.BARRAdoesnotwarrantthattheUnitedStatesEquityRiskModelwillbefreefromunauthorizedhiddenprogramsintroducedintotheUnitedStatesEquityRiskModelwithoutBARRA'sknowledge.CopyrightBARRA,Inc.1998.Allrightsreserved.0111O02/98iContentsAboutBARRA....................................1Apioneerinriskmanagement.............................1Introduction.....................................3Inthishandbook.........................................3Furtherreferences.......................................5Books...............................................5SectionI:Theory1.WhyRiskisImportant...........................7Thegoalofriskanalysis...................................82.DefiningRisk.................................11Somebasicdefinitions....................................11Riskmeasurement......................................13Anexample............................................13Riskreductionthroughdiversification.....................14Drawbacksofsimpleriskcalculations.....................16Evolutionofconcepts...................................163.ModelingandForecastingRisk...................21WhatareMFMs?.......................................21HowdoMFMswork?...................................21AdvantagesofMFMs....................................22AsimpleMFM.........................................23Modelmathematics.....................................25RiskpredictionwithMFMs..............................26iiU.S.EquityModelVersion3(E3)4.ModernPortfolioManagementandRisk...........31Portfoliomanagement—twotypes........................31Passivemanagement.................................31Activemanagement..................................32Decomposingrisk.......................................34TotalRisk..........................................34Systematic-ResidualRiskDecomposition...............35ActiveRiskDecomposition...........................36ActiveSystematic-ActiveResidualRiskDecomposition...37Summaryofriskdecomposition..........................38Performanceattribution.................................38Summary..............................................395.BARRAMultiple-FactorModeling.................41Overview..............................................41Descriptorselectionandtesting...........................44Descriptorstandardization...............................44Riskindexformulation..................................45Industryallocation......................................45Factorreturnestimation.................................46Covariancematrixcalculation............................46Exponentialweighting...............................47Computingmarketvolatility:ExtendedGARCHmodels............................48Specificriskmodeling...................................49Overview...........................................49Methodology.......................................50Modelingtheaveragelevelofspecificrisk...............50Modelingtherelativelevelofspecificrisk...............51Estimatingthescalingcoefficients.....................52Finalspecificriskforecast.............................52Updatingthemodel.....................................52Comparisonofriskmodelfeatures........................53ContentsiiiSectionII:US-E3ModelDetails6.AdvantagesofUS-E3OverUS-E2.................55Overview..............................................55Industries..............................................56Reclassification......................................56Flexibleindustries...................................57Increasedsizeoftheestimationuniverse...................57Riskindices............................................58SizeNonlinearityfactor..............................58Leverage...........................................58Simplervolatilitycalculation..........................58EliminationofUS-E2’sLaborIntensityandForeignIncome..................................59Improvedindependencebetweenriskindices...........59Riskforecasting.........................................59ImprovedGARCHmodel............................59Specificriskmodel...................................60Modelfit-relatedissues..................................60Factorreturnestimation..............................60Ongoingdiagnostics.................................60Scheduledrefittingofmodelparameters..........