Sector Exposure Models For Risk Management of Security Portfolio

Portfolio optimization requires the minimal risk with certain expected return. The risk structure of securities, such as their exposure to countries, industrial sectors, or commodity/factor, have to be characterized, and then the optimal weights of securities in a portfolio can be determined to minimize the exposure of the portfolio to any specific risk factor. Typically, the risk factors are not independent, for example, the health and pharmaceutical industries generally have positive correlation. Besides, the expected return of a security is also related to its exposure to certain risk factors. Therefore, the portfolio optimization, or risk management, cannot be done by simply minimizing the exposure of the portfolio to each single risk factor independently. Instead, an efficient portfolio frontier can be constructed by Markowitz portfolio theory . However, the statistical input requirements to apply Markowitz portfolio theory in a large portfolio are significant. Specifically, we must estimate the expected returns and the covariance matrix, which becomes difficult for a large portfolio and the Sector Exposure Model, or the Multifactor Model, becomes necessary to achieve this goal. Therefore, the objectives of developing sector exposure models are two-fold: help us in understanding and controlling the exposure of our portfolio to any specific risk factor, and implementing portfolio optimization or risk management.