Two steps methodology with scarce observations

by Alexander Cherny, Raphael Douady & Stanislav Molchanov, 2008

We propose a methodology for estimating the risk of portfolios that exhibit nonlinear dependence on the risk driving factors and have scarce observations, which is typical for portfolios of investments in hedge funds. The methodology consists of two steps: first, regressing the portfolio return on nonlinear functions of each single risk driving factor and second, merging together the obtained estimates taking into account the dependence between different factors. Performing the second step leads us to a certain probabilistic problem, for which we propose an analytic and computationally feasible solution for the case where the joint law of the factors is a Gaussian copula.

A typical practical application can be to estimate the risk of a hedge fund or a portfolio of hedge funds. As a theoretical consequence of our results, we propose a new definition of the factor risk, i.e., the risk of a portfolio brought by a given factor.