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Article

Factor Risk Model and Portfolio Construction with a Focus
on Surplus Risk

Chunlan Wang, Elaine Su, Dmitry Pevzner and Artan Ajazaj
The Journal of Index Investing Summer 2014, 4 (1) 62-69; DOI: https://doi.org/10.3905/jii.2013.4.1.062
Chunlan Wang
is a senior investment officer at the World Bank in Washington, DC.
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  • For correspondence: cwang@worldbank.org
Elaine Su
is a senior financial officer at the World Bank in Washington, DC.
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  • For correspondence: esu@worldbank.org
Dmitry Pevzner
is a senior investment officer at the World Bank in Washington, DC.
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  • For correspondence: dpevzner@worldbank.org
Artan Ajazaj
is an investment officer at the World Bank in Washington, DC.
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  • For correspondence: aajazaj@worldbank.org
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Abstract

We examine asset classes through a single-factor lens, using a factor risk model that enhances the transparency and consistency of portfolio construction and risk management. We show how risk factors can be used as building blocks for diversification and apply factor analysis to asset-class bucketing, asset allocation, manager evaluation, and risk management. We contrast the intuitive features of a traditional approach with our hybrid approach, which calculates the risk decomposition based on three drivers including factor loading, stand-alone risk, and correlation. We provide immediate insight as to how the impact to total risk and surplus risk is caused by various dimensions and sliced buckets, and we show where to further modify and manage risk exposure through correlation decomposition. Finally, we provide risk-analysis cases, using the implemented factor risk model.

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The Journal of Index Investing: 4 (1)
The Journal of Index Investing
Vol. 4, Issue 1
Summer 2014
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Factor Risk Model and Portfolio Construction with a Focus
on Surplus Risk
Chunlan Wang, Elaine Su, Dmitry Pevzner, Artan Ajazaj
The Journal of Index Investing May 2013, 4 (1) 62-69; DOI: 10.3905/jii.2013.4.1.062

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Factor Risk Model and Portfolio Construction with a Focus
on Surplus Risk
Chunlan Wang, Elaine Su, Dmitry Pevzner, Artan Ajazaj
The Journal of Index Investing May 2013, 4 (1) 62-69; DOI: 10.3905/jii.2013.4.1.062
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  • Article
    • Abstract
    • FACTOR MODEL: LOOKING THROUGH ASSET CLASS INTO THE UNDERLYING RISK FACTORS
    • HYBRID APPROACH: PORTFOLIO APPLICATIONS
    • FACTOR RISK MODEL IMPLEMENTATION AND RISK MANAGEMENT
    • CONCLUSION
    • ENDNOTES
    • REFERENCES
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