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Disentangling Systematic and Idiosyncratic Risk for Large Panels of Assets

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Abstract
When observed over a large panel, measures of risk (such as realized volatilities) usually exhibit a secular trend around which individual risks cluster. In this article we propose a vector Multiplicative Error Model achieving a decomposition of each risk measure into a common systematic and an idiosyncratic component, while allowing for contemporaneous dependence in the innovation process. As a consequence, we can assess how much of the current asset risk is due to a system wide component, and measure the persistence of the deviation of an asset specific risk from that common level. We develop an estimation technique, based on a combination of seminonparametric methods and copula theory, that is suitable for large dimensional panels. The model is applied to two panels of daily realized volatilities between 2001 and 2008: the SPDR Sectoral Indices of the S&P500 and the constituents of the S&P100. Similar results are obtained on the two sets in terms of reverting behavior of the common nonstationary component and the idiosyncratic dynamics to with a variable speed that appears to be sector dependent.

Suggested Citation

  • Matteo Barigozzi & Christian T. Brownlees & Giampiero M. Gallo & David Veredas, 2010. "Disentangling Systematic and Idiosyncratic Risk for Large Panels of Assets," Econometrics Working Papers Archive wp2010_06, Universita' degli Studi di Firenze, Dipartimento di Statistica, Informatica, Applicazioni "G. Parenti".
    • Handle: RePEc:fir:econom:wp2010_06
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    File URL: https://labdisia.disia.unifi.it/ricerca/pubblicazioni/working_papers/2010/wp2010_06.pdf
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    References listed on IDEAS

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    2. Fady Barsoum, 2013. "The Effects of Monetary Policy Shocks on a Panel of Stock Market Volatilities: A Factor-Augmented Bayesian VAR Approach," Working Paper Series of the Department of Economics, University of Konstanz 2013-15, Department of Economics, University of Konstanz.
    3. Bollerslev, Tim & Todorov, Viktor & Li, Sophia Zhengzi, 2013. "Jump tails, extreme dependencies, and the distribution of stock returns," Journal of Econometrics, Elsevier, vol. 172(2), pages 307-324.
    4. Matteo Luciani & David Veredas, 2012. "A model for vast panels of volatilities," Working Papers 1230, Banco de España.
    5. Bernard Herskovic & Bryan Kelly & Hanno Lustig & Stijn Van Nieuwerburgh, 2020. "Firm Volatility in Granular Networks," Journal of Political Economy, University of Chicago Press, vol. 128(11), pages 4097-4162.
    6. Matteo Luciani & David Veredas, "undated". "A simple model for vast panels of volatilities," ULB Institutional Repository 2013/136239, ULB -- Universite Libre de Bruxelles.

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    More about this item

    Keywords

    Systematic risk; idiosyncratic risk; Multiplicative Error Model; seminonparametric; copula.;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • G01 - Financial Economics - - General - - - Financial Crises

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