Portfolio risk management in a data-rich environment
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We study risk assessment using an optimal portfolio in which the weights are functions of latent factors and firm-specific characteristics (hereafter, diffusion index portfolio). The factors are used to summarize the information contained in a large set of economic data and thus reflect the state of the economy. First, we evaluate the performance of the diffusion index portfolio and compare it to both that of a portfolio in which the weights depend only on firm-specific characteristics and an equally weighted portfolio. We then use value-at-risk, expected shortfall, and downside probability to investigate whether the weights-modeling approach, which is based on factor analysis, helps reduce market risk. Our empirical results clearly indicate that using economic factors together with firm-specific characteristics helps protect investors against market risk.
KeywordsPortfolio weights modeling Factor analysis Principal components Portfolio performance Value-at-risk Expected shortfall Downside probability
JEL ClassificationC13 C43 G11 G19
We thank an anonymous referee and the Co-Editor Markus Schmid for their very helpful comments. We also thank Kenneth French and Mark Watson for making the data available to us. The first author acknowledges financial support from IFM2, Montreal, and the second author acknowledges financial support from the Spanish Ministry of Education through Grants SEJ 2011-0031-001.
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