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Custom v. Standardized Risk Models

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  • Zura Kakushadze
  • Jim Kyung-Soo Liew

Abstract

We discuss when and why custom multi-factor risk models are warranted and give source code for computing some risk factors. Pension/mutual funds do not require customization but standardization. However, using standardized risk models in quant trading with much shorter holding horizons is suboptimal: 1) longer horizon risk factors (value, growth, etc.) increase noise trades and trading costs; 2) arbitrary risk factors can neutralize alpha; 3) "standardized" industries are artificial and insufficiently granular; 4) normalization of style risk factors is lost for the trading universe; 5) diversifying risk models lowers P&L correlations, reduces turnover and market impact, and increases capacity. We discuss various aspects of custom risk model building.

Suggested Citation

  • Zura Kakushadze & Jim Kyung-Soo Liew, 2014. "Custom v. Standardized Risk Models," Papers 1409.2575, arXiv.org, revised May 2015.
  • Handle: RePEc:arx:papers:1409.2575
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    References listed on IDEAS

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