4 – M4 L2A 15 Time Series Risk Model V2

If we look again at our risk model, we can see that we’ve got estimates for each of the variables in several of these matrices. In particular, we are able to fill in the matrix of factor variances and covariances, the matrix of factor exposures and the matrix of specific variances. The product of factor exposures to factor variances and covariances plus specific variances is essentially the covariance matrix of the stocks. The stock weights in the matrices at the left and right end of this expression can be multiplied to this covariance matrix of assets to get the portfolio variance. In a later lesson, you’ll learn about choosing optimal portfolio weights. But for now, you can think of that inner core, the covariance matrix of assets, as the plug-and-play component that we can insert into various portfolios that contained a subset of the assets contained in that matrix.

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