Understanding the sources of financial risk: a three-mode factor model for stock returns

In terms of communication, today’s world benefits from being globally connected—but so, too, are our finances. The downside is that when one brick crumbles, the whole structure can be weakened, as the Global Financial Crisis made clear. Even taking the precaution of diversifying our investments is difficult, because so many different markets move together. Luca Repetto saw here a need for real improvement and, with his research, is aiming for better methods of identifying where the variability in financial assets comes from: shocks to the system at the country level, for instance? Or the industry level?
Models of such financial behavior are often built on common factors, variables that affect all members of a category (e.g. countries, industries) at once. These can then be enhanced with factors specific to a sector or region. The trouble is that, in the past, this specificity has just been assumed, but to know if a “Euro-area factor” truly affects only the European economy, this must be tested. So far, Luca has developed a formal way of testing this that will have multiple applications: in finance, to look for a risk-free asset in the economy, or in macroeconomics, to identify a factor of inflation that affects all prices equally, to name just two. As he continues to build on his method, Luca’s work should make it possible to diversify portfolios at both country and industry levels, and contribute to a better understanding of how these are linked throughout the global economy.