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Financial risk modeling is the use of formal mathematical and econometric techniques to measure, monitor and control the market risk, credit risk, and operational risk on a firm's balance sheet, on a bank's accounting ledger of tradeable financial assets, or of a fund manager's portfolio value; see Financial risk management.
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In the risk model industry factors carry about half the explanatory power after the market effect is accounted for. However, Rosenberg had left unsolved how the industry groupings should be defined – choosing to rely simply on a conventional set of industries. Defining industry sets is a problem in taxonomy.
[1] [2] See Finance § Risk management for an overview. Financial risk management as a "science" can be said to have been born [3] with modern portfolio theory, particularly as initiated by Professor Harry Markowitz in 1952 with his article, "Portfolio Selection"; [4] see Mathematical finance § Risk and portfolio management: the P world.
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[1] [2] A risk factor is a concept in finance theory such as the capital asset pricing model, arbitrage pricing theory and other theories that use pricing kernels. In these models, the rate of return of an asset ( hence the converse its price ) is a random variable whose realization in any time period is a linear combination of other random ...
The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.