19-EquityPort Page 579 Friday, March 12, 2004 12:40 PM
Equity Portfolio Management 579EXHIBIT 19.5 Total Risk DecompositionSource: Figure 4.2 in Barra, Risk Model Handbook United States Equity: Version
3 (Berkeley, CA: Barra, 1998), p. 34. Reprinted with permission.total risk decomposition approach just described, this view brings mar-
ket risk into the analysis.
Residual risk in the systematic-residual risk decomposition is
defined in a different way than residual risk is in the total risk decompo-
sition. In the systematic-residual risk decomposition, residual risk is risk
that is uncorrelated with the market portfolio. In turn, residual risk is
partitioned into specific risk and common factor risk. Notice that the
partitioning of risk described here is different from that in the APT
model described earlier in this chapter. In that section, all risk factors
that could not be diversified away were referred to as “systematic
risks.” In our discussion here, risk factors that cannot be diversified
away are classified as market risk and common factor risk. Residual risk
can be diversified to a negligible level.Active Risk Decomposition
The active risk decomposition approach is useful for assessing a portfolio’s
risk exposure and actual performance relative to a benchmark index is
explained. that purpose. In this type of decomposition, shown in Exhibit
19.7, the total excess return is divided into benchmark risk and active risk.