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Risk Model Definition, Overview and Quiz

In the chasm between retail and institutional investing sits a hidden tool unavailable to most due to cost, awareness and complexity.
  1. Define - Define and describe an investment risk model.
  2. Context - Use risk model in a sentence.
  3. Quiz - Test yourself.
face pic by Paul Alan Davis, CFA
Updated: February 18, 2021
While portfolio theory indicates all investors forecast risk. We know this assumption is far from reality. Learn more below.

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The Business Case for Implementing a Risk Model


Risk Model is a quantitative tool for forecasting risk for each security in a coverage universe. Risk models include forecasts of variance for each security and the covariance between each pair of securities, or factors.

Risk models are used for risk analysis and portfolio optimization. The three versions of third-party risk models and example factors include:

Factor models are generated from a multi-factor regression which results in a covariance matrix of factors (ie, size, style, sector) instead of individual security co-movements.

Synonyms: Arbitrage Pricing Theory model, APT model

The process of building a risk model for sale is an endeavor typically attempted only by large service providers like Barra, Axioma, Wilshire, BlackRock and Bloomberg. These firms have large budgets and staff to access and clean investment data on over 25,000 equities globally. Besides this, the technical know-how requires teams of PhD-level employees to review and hypothesize ways in which past data can be statistically screened, categorized and standardized into a tool that predicts risk better than using past observations alone.

It is for this reason that most individuals and professionals, like brokers, financial planners and wealth managers, ignore risk models altogether. Many institutional investors on the other hand subscribe to third-party models in conjunction with their data providers and other software tools. Few firms develop risk models in house.

In a Sentence

Tim:  Have you heard what we spend on Ann's risk model every year?
Kay:  Nope. It's a closely guarded secret, and you know what that means.


Many terms have 4-5 minute videos showing a derivation and explanation. If this term had one, it would appear here.

Videos can also be accessed from our YouTube Channel.

Video Script

If this term had a video, the script would be here.


Click box for answer.

A fundamental factor risk model normally has fewer cells than a historical model of individual stocks. | True or False?


A 100-company stock-by-stock historical risk model has how many cells in the covariance matrix? | 100 or 1,000 or 10,000?

10,000 is the number of cells in a 100-by-100 covariance matrix.

Questions or Comments?

Still unclear on the concept of a Risk Model? Check out the 27-video free tutorial series in Excel called Quant 101 where we walk through risk modeling from the start.

Related Terms

Our trained humans found other terms in the category forecasting models you may find helpful.

What's Next?

To learn more about risk, subscribe to the FactorPad YouTube Channel. Our Twitter handle @factorpad is for new content announcements.

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/ factorpad.com / fin / glossary / risk-model.html

investment risk model
apt model
arbitrage pricing theory model
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coverage universe
forecast variance
factor covariance matrix
risk factors
investment risk matrix
security risk forecast
fundamental factor risk
asset risk model
macroeconomic factor model
statistical factor model
investment risk analysis
portfolio optimization
stock risk model

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