Modeling Value at Risk with Factors

Oct 1, 2009

Factor models are standards in investment management. For decades, Barra factor models have provided valuable risk forecasts and inputs for the portfolio construction process. Most uses of factor models have targeted longer horizons of months or years. However, we demonstrate in this paper that factor models can also provide accurate risk forecasts for shorter horizons of one to ten days. Furthermore, factor models have the advantage of explaining risk sources and providing consistency in risk management processes across all time horizons.We present a factor model with a methodology appropriately tailored to shorter horizons. Our basic approach is to retain the same common risk factors currently used in the Barra Integrated Model (BIM) and adopt a number of techniques that exploit daily data. As we show for different asset classes, markets, and sectors, this factor model approach yields similarly accurate shorter horizon risk forecasts compared to asset-by-asset approaches.