Advanced Idiosyncratic Risk and Multi-Factor Models – Short Version
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
