ABSTRACT
The 21st century has already been marked by three fundamental paradigm shifts related to how we understand and model financial markets, behavior – the incorporation of non-Gaussian processes to represent extreme market events, Modern Portfolio Theory (MPT) modification to account for behavioral biases and market participants' preferences, and most recently the need to include exogenous factors into the modeling considerations. The latter can be representative of the so-called novel risk factors which arise from environmental-, governance-, healthcare-, political-, policy-, and technology-related and other similar potential disruptions and can be characterized by (1) being factors external to the financial system itself, (2) requirements to be assessed based on alternative data and (3) not yet been priced by the market or, in other words, the markets are effectively not yet efficient with regard to these novel phenomena. While the first of the above-mentioned fundamental shifts has well-developed theoretical modeling foundations and the second one accumulates a body of research, the study of the latter one is still a fundamentally open question. Within this chapter, we will offer a general framework for modeling exogenous novel risk factors in an integrated framework via the notion of multi-subordinated Lévy processes. The approach introduces a unified framework for consistent integration of traditional and novel types of risk and can serve for both risk budgeting and asset-allocation applications.
