APPLICATION: FACTOR ANALYSIS

In risk management, factor analysis is a form of risk attribution, which attempts to identify and measure common sources of risk within large, complex portfolios.1 These underlying sources of risk are known as factors. Factors can include equity market risk, sector risk, region risk, country risk, interest rate risk, inflation risk, or style risk (large-cap versus small-cap, value versus growth, momentum, etc.). Factor analysis is most popular for equity portfolios, but can be applied to any asset class or strategy.

In a large, complex portfolio it is sometimes far from obvious how much exposure a portfolio has to a given factor. Depending on a portfolio manager's objectives, it may be desirable to minimize certain factor exposures or to keep the amount of risk from certain factors within a given range. It typically falls to risk management to ensure that the factor exposures are maintained at acceptable levels.