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Orthogonalized Equity Risk Premia and Systematic Risk Decomposition

Author

Listed:
  • Rudolf F. Klein

    (Department of Economics, West Virginia University)

  • K. Victor Chow

    (Department of Finance, West Virginia University)

Abstract

To solve the dependency problem between factors, in the context of linear multi-factor models, this study proposes an optimal procedure to find orthogonalized risk premia, which also facilitates the decomposition of the coefficient of determination. Importantly, the new risk premia may diverge significantly from the original ones. The decomposition of risk allows one to explicitly examine the impact of individual factors on the return variation of risky assets, which provides discriminative power for factor selection. The procedure is experimentally robust even for small samples. Empirically we find that even though on average, approximately eighty (sixtyfive) percent of style (industry) portfolios’ volatility is explained by the market and size factors, other factors such as value, momentum and contrarian still play an important role for certain portfolios. The components of systematic risk, while dynamic over time, generally exhibit negative correlation between market, on one side, and size, value, momentum and contrarian, on the other side.

Suggested Citation

  • Rudolf F. Klein & K. Victor Chow, 2010. "Orthogonalized Equity Risk Premia and Systematic Risk Decomposition," Working Papers 10-05, Department of Economics, West Virginia University.
  • Handle: RePEc:wvu:wpaper:10-05
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    File URL: http://be.wvu.edu/phd_economics/pdf/10-05.pdf
    File Function: First version, 2010
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    References listed on IDEAS

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    Cited by:

    1. Wolfgang Bessler & Julian Holler & Philipp Kurmann, 2012. "Hedge funds and optimal asset allocation: Bayesian expectations and spanning tests," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 109-141, March.

    More about this item

    Keywords

    Orthogonalization; Systematic Risk; Decomposition; Fama-French Model; Asset Pricing.;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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