Concept · The RiskModels engine (ERM3)
L-star rule
The L\* rule: a cost-aware, learned selector that picks the shallowest level whose expected out-of-sample variance reduction outweighs the added hedging cost of going deeper — describing a name at the coarsest level that still captures its risk. Scored point-in-time, so the dispatch is backtest-safe.
In depth
Picks the simplest level whose marginal explained return clears a threshold θ (default 1%, tuned on 275 tickers over 60 months). Keeps descriptions at the coarsest level that still captures a name's risk.
Formula
L* = L3 if ER^L3_sub ≥ θ; L2 elif ER^L2_sec ≥ θ; else L1
In the methodology
Choosing a level: the L* rule →Referenced by (3)
- Every Position Has a Level Too
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- Cascade Hedging and the Cost of Interpretability
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- ERM3 Cascade-Residual Persistence and the Allocator Skill Signal
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