Chapter 9

Portfolio Risk Management and

Linear Factor Models

9.1 Portfolio Risk Measures

There are many quantities introduced over the years to measure the level of risk
that a portfolio carries, and each has its own special emphasis. Here we list several
of them.

A. Volatility
The volatility of a stock return is the most common measure to describe the
risk level. It is defined as the standard deviation of a return per unit time.
When a quote of volatility σ is given, we can expect the variance of the return
over certain time period ∆t to be σ 2 ∆t. If we further assume that the return
has normal distribution,
√ we can √even say that the probability for the return to
be within (µ∆t−σ ∆t, µ∆t+σ ∆t) is about 0.68, where µ∆t is the expected
return over the period ∆t. The disadvantage of this measure is that there is
no way to distinguish between up moves and down moves. In reality, many
investors view the risk as adverse movements and this is not reflected well in
the volatility measure.

B. Sharpe Ratio
This quantity measures the reward for taking risk, and it is defined as

E [RP ] − r
S(P ) =
σP
The larger the Sharpe ratio, the more reward the investor will receive when
the same amount of risk level is taken. For example, suppose portfolio A has
Sharpe ratio 1, while portfolio B has Sharpe ratio 1.2. If their volatilities are
the same at 20%, and the risk-free rate is 2%, then the expected return of
portfolio A will be 22% and the expected return of portfolio B will be 26%.
If we look at the Markowitz bullet and consider portfolios consisting of the

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 CML (Capital Market Line)
µ

0.24

market portfolio
0.16
E[R_P]

Markowitz Bullet

0.08

(0,0.05)

0 0.08 0.16 0.24 0.32 0.4 0.48

σ_P

-0.08

Figure 9.1: Sharpe ratio of the market portfolio as the slope of CML

risk-free asset and a risky portfolio on the frontier, then we find that those
portfolios corresponding to the CML line will have the highest Sharpe ratio,
which is the slope of the CML line.
In a leveraged fund, the Sharpe ratio stays the same, so the expected return
can be estimated by the Sharpe ratio and the risk level that is taken.

Example 1 Suppose the risk-free interest rate r = 4%, and we have two port-
folios with known expected returns and volatilities. We can calculate their in-
dividual Sharpe ratios and use them to make a decision as which portfolio is to
be preferred. Portfolio 1 has higher expected return and comes with higher level

E[R] σP S(P )
Portfolio 1 17 % 9% 1.44
Portfolio 2 15 % 5% 2.2

of risk as expected. Does that high risk level really justify, in light of another
portfolio to be compared? One measure to look is the Sharpe ratio, in this case
the portfolio 2 wins as its Sharpe ratio stands at 2.2, substantially higher than
1.44, the Sharpe ratio of portfolio 1.

C. Sortino Ratio
As we point out earlier, one disadvantage of the volatility measure is that it does
not distinguish between the upward and downward moves. If only downward
moves are counted as risk, we can introduce a modified fluctuation indicator
that ignores upward moves. Suppose Xi is the observed return on day i, we
introduce 
a Xi ≥ a
Yi =
Xi Xi < a

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 and define the downside sample semivariance as
n n
1X 1X
σa2 = (Yi − a)2 = [min{0, Xi − a}]2
n i=1 n i=1

Now if you want to count only downward moves, you can pick a = 0 in the
above measure.

D. Maximum Drawdown
A drawdown is a streak of losses without substantial recovery, and it can be
viewed as a peak-to-trough drop. Some investors are particularly sensitive to
these occurrences and they fear the worst: a huge drawdown without a major
break. One imagines that he/she bought the security at the peak and sold at
the trough, which is the worst case that can happen to an investment. The
maximum drawdown is like a worst case scenario, and many investors would
particularly focus on them to see how much they can take. The exact definition
for the maximum drawdown for a period [0, T ] is as follows

M DD(T ) = max (V (u) − V (v))

0≤u≤v≤T

This definition involves taking maximum over two variables, and it can be
awkward to work with. Actually it can be shown that it is equivalent to

M DD(T ) = max (M (t) − V (t)) ,

0≤t≤T

where
M (t) = max V (u)
u∈[0,t]

is the maximum value achieved by the time t.

E. Value-at-Risk (VaR)
VaR is probably the most widely used risk measure in the financial industry,
and it gives the risk management a sense of damage control. The measure is
better described using probability terms: Given p ∈ (0, 1), the value-at-risk of
a random variable X (it could be a return, a profit-and-loss, etc) for the level
of probability p is denoted by

VaRp (X) = FX−1 (p) = min {x | FX (x) ≥ p} = Q(p)

In another word, the p-VaR is the lowest p-quantile of X. Here FX (x) = P{X ≤
x} is the CDF of the random variable X.
Notice that there are other versions of the VaR, and here we mostly use X as
the gain/loss of certain portfolio. We use the following examples to illustrate
the use and sense of a VaR quote.

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 Example 2 Suppose we are told that a stock portfolio with a one-day p-VaR
is $20,000, with p = 1%. The meaning of this quote is that the probability for
the one-day loss X to go over $20,000 is 0.01.

Example 3 In this example, we consider a single asset with initial value V =

$100, 000, and an annual return denoted by the random variable R ∼ N (0.14, 0.352 )
(this says that µ = 14% and σ = 35%). With p = 1%, what is the maximum
loss at the end of the year?
First we can look up the normal distribution table to find the 1%-tile value
Z1% ≈ −2.33. For the distribution of R, it means
 
R − 0.14
P [Z ≤ −2.33] = P ≤ −2.33 = P [R ≤ −0.6743] = 0.01
0.35
There is 1% chance that the stock can lose more than 67% of its value. So the
dollar amount of loss can be more than $67,433.

Methods to estimate VaRs can be categorized into the following:

• Historical methods: using data from the past;
• Variance-covariance methods;
• Monte Carlo simulation methods.

9.2 Introduction to Linear Factor Models

Suppose we need to model a collection of assets and it is natural to use a stochastic
model such as the Black-Scholes for each asset. The random factors for these
assets, more particularly the covariance matrix, will become the focus. Once the
number of assets becomes large, the system will become more and more difficult
to manage. In macroeconomical factor models, our economic understanding of
the market suggests that we should be able to use some fundamental factors to
explain a large part of the stock movements. On the other hand, in statistical
factor models we use statistical methods to ”discover” these important factors
that are responsible for most of the movements.

Definition 1 A (linear) factor model relates the return of an asset of a portfolio

to the values of a limited number of factors, say fj , j = 1, . . . , m

Ri = βi1 fi + βi2 f2 + · · · + βim fm + ei

where
• βij : sensitivity of asset i to factor j,
• ei : portion of the return that is not related to the m factors (idiosyncratic
return)

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We then have the following questions (and answers):

• How can we estimate βij ? (Linear regression).

• How do we model ei ? We let

ei = αi + i , with E[i ] = 0.

Now we can write the linear factor model as

m
X
Ri = αi + βik fk + i
k=1

For different assets i and i0 , we usually assume

Cov(i , i0 ) = 0, and Cov(i , fk ) = 0.

What are these factors? If you work with a macroeconomical factor model, you
could suggest some based on economic principles. In these statistical factor models,
we aim at the following two aspects:

1. The number of factors (m) hopefully is not large.

2. The factors f˜j , j = 1, . . . , m are uncorrelated:

Cov(f˜j , f˜j 0 ) = 0 for j 6= j 0 , and Cov(i , i0 ) = 0 for i 6= i0 ,

Then we have the linear factor model

m
X
Ri = αi + βik f˜k + i
k=1

The coefficients βik are called factor loading coefficients. In matrix form we can
write
R = α+βf +
and the covariance matrix can be decomposed as

Cov(R) = β Cov(f ) β T + Cov()

The significance of this decomposition can be explained as follows:

1. Factor models allow risk managers to perform risk management by approach-

ing factors in a direct way.

2. We can allocate portfolios based on the risk profile.

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9.3 Alpha and Beta
In a very simple form, we can write the return of an asset as

R = α + βRM + 

where RM is the return of the market, and  is the idiosyncratic return with mean
zero. We can see that α is the part of the return in excess to the market, and β
is the sensitivity to the market. If we have available data, we can use regression
(such as least square fit to a line) to come up with a line in the (RM , R) plane.
This can be extended to several factors. One example of fundamental factor models
is the Fama-French three-factor model, where the factors are

• market

• size of the company

• book/price ratio

Following CAPM, In this case we can write the model as

R − r = α + β1 (Rm − r) + β2 (RS − RB ) + β3 (RH − RL ) + 

where the first factor refers the market return over the risk-free rate, the second
refers the premium caused by small size vs big size of the company, and the third
factor refers the premium generated by a high book/price ratio vs a low book/price
ratio.