Quant · Core
Idiosyncratic Risk
Idiosyncratic risk is residual variance after the factors — name-specific noise that diversification is supposed to shrink.
Definition
ε in r = α + β′F + ε. Single-name events (fraud, a drug trial, a CEO) live here. In a well-specified model the residual is uncorrelated across names. In a bad model, ‘idio’ is a missing factor.
Why it matters
Active risk budgets and pair trades are idio claims. A crowded residual is not residual.
Case
A pair trade that was ‘idio’ until both names were the same dealer-prime-broker unwind. The residual correlated because the financing did.
How to read it
If many residuals jump together, add a factor. Position size to the residual vol you actually measure.
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