Correlation, co-dependency and risk aggregation [15]

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Bullet points include: Two potential approaches. beta (and hence factors) includes idiosyncratic risk, or More commonly, beta (and hence factors) excludes idiosyncratic risk. If idiosyncratic risk of j’th security is sigma j then: More generally, some securities may have correlated ‘idiosyncratic’ risk (e.g. equities of the same company listed in different locations, bonds with the same issuer, ...), then as follows, where Y is a (very) sparse m x m matrix

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