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Comparing Specific Risk Forecasting Methodologies

Since specific risk is the only risk that can be reduced through diversification, it is crucial to obtain an accurate specific risk forecast.  Stock pickers target specific returns, and the active return on which they base their businesses primarily bears specific risk. Specific risk models are especially vulnerable to misforecasting during periods of rapidly changing risk. Are there specific risk models that can follow such large variations and produce forecasts that do not mislead? This paper explores the relative merits of different methods for forecasting the specific risk of individual assets.  The methods include what we will term historical estimation, the Parkinson technique, and structural modeling.