Decomposition of Portfolio Risk into Independent Factors Using an Inductive Causal Search Algorithm

A method is presented to estimate and decompose a portfolio's risk along independent factors. This decomposition is based upon a market's underlying independent risk factors, which are found empirically by using an inductive causal search algorithm that is based on independent component analysis. Since independent risk factors can be understood to always add risk to a portfolio, a portfolio manager can use them to better understand and budget risk. In contrast, portfolio management using the classic marginal analysis is confusing because adding a risky security to a portfolio might actually reduce the portfolio's risk. In a small application using the six most widely traded currencies (the Australian dollar, Canadian dollar, euro, sterling, Japanese yen and US dollar), independent-factor risk contributions are constrained during portfolio optimizations, and the internal risk characteristics of the resulting portfolios are found to compare favorably with those created by using constraints on the risk contributions of the original assets.