Hedging Against Asian Crisis Risk with MSCI ACWI Derivatives

Transcription

1 Hedging Against Asian Crisis Risk with MSCI ACWI Derivatives

2 Bland Title, but I m Trying to Present Two Papers On Crisis Risk Hedging Proposal # 1 Global Index Puts: There doesn t seem to be a global analog of the ASX or SP500 Index Options (if you exclude the EAFE Exchange Traded Fund Puts sold at the CBOE). So I explore one Proposal # 2 Global Benchmark Insurance: It may be worth replicating the act of selling off a country s assets using exchange options

3 What Data Do I Use? I use US dollar denominated rates of return computed from daily index closing values for Morgan Stanley Capital International s All Country World Index, 30/06/95 11/01/06 18 of S&P/IFC s Emerging Market Investable Indices, 30/06/95 11/01/06

4 Why the ACWI? I used to use the All World Actuaries Index to proxy global investment opportunities, but it s changed hands so many times, and there are a few outlier returns I can t explain I think Morgan Stanley Capital International does a good job trying to be consistent across all of its indices

5 Also, Why Am I Bothering With This? Reason #1 Did You See How Slow and Inadequate the Official response was during the Asian Crisis? [Note: I m not pointing fingers, but there must be a better way] Reason #2 After so many papers, we re still only debating about the causes of crises

6 Some Necessary Conditions to Hedge Against Asian Crisis Risk Necessary Conditions 1) You need to know how to quantify the risk - Use COUNTRY BETAS and COUNTRY ALPHAS 2) You need to know how to price the risk - use 1) MSCI ACWI index put options, or 2) exchange options constructed from MSCI ACWI call options, together with country index put options

7 A Sufficient Condition to Hedge Against Asian Crisis Risk Sufficient Condition If the crisis hedging product is cheap, global investors will buy But there s no guarantee that it ll be cheap [I ll show you later]. So, you can lead a horse to water, but you can t make it drink

8 Proposal # 1: Quantifying the Risk of Financial Crises With Country Betas Scholes-Williams (1977) method corrects country risk for the fact that trading does not occur synchronously across markets: SW Beta - Country Risk SW Beta S.E. s (I won t have time to explain) σ ρ 2 S 1+ 2 ekt e σ β S = kwt 2 ω 2 βwt,3wt S kt σ ρ 2 r 3wt 3w, t

9 Keep these, throw out everything else Scholes and Williams s (1977) Estimator: First Estimate the Following, 250-trading day, Rolling Regressions

10 then Estimate the Following, 250-trading day, Rolling Autoregression for the World Portfolio Keep this, throw out everything else

11 r r By the Way, Why Not Use Conditional Betas? As an example for Indonesia against ACWI k, t w, t First Estimate the Burns, Engle, Mezrich, Journal of Derivatives (1998) model, akk,0 0 a kk,0 akw,0 H t = + akw,0 a ww,0 0 a ww,0 akk,1 a wk,1 ε k, t 1 a μ k = + ε k, t mkk m ε kw k, t 1 ( ) + ε k, t 1 ε w, t 1 akw,1 a ww,1 ε w, t 1 a μw ε w, t mwk mww ε w, t 1 2 akk,2 a wk,2 σ k, t 1 σ k, w, t 1 akk 2 akw,2 a ww,2 σ k, w, t 1 σ w, t 1 a wk Then, for two different samples, compute the difference between the two term structures for the overlapping portion, and you get kk,1 wk,1,2,2 a a a a kw,1 ww,1 kw,2 ww,2 +

12 Conclusion: Conditional Risk Estimates are Too Unstable Differences Within M-GARCH Term Structures /03/ /03/ /03/ /03/ /03/ /03/2000 Time Note: I m trying to Create a Historical Series of Risk Estimates, so I d like the difference to be zero

13 China: Daily SW Country Betas & S.E. s Brazilian real band widens Asian Crisis ends Russian default IM F b a ilo u t o f In d o n e s ia Thai baht floats /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/2003 Time Country Beta Korean won floats Malaysian short sale ban Taiwan new dollar floats

14 Indonesia: Daily SW Country Betas & S.E. s Suharto steps down Thai baht floats Russian default Brazilian real band widens Asian Crisis ends 06/20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/2003 Time Country Beta Malaysian short sale ban Korean won floats IM F bailout of Indonesia Taiwan new dollar floats

15 Thailand: Daily SW Country Betas & S.E. s Thai baht floats Russian default Brazilian real band widens Asian Crisis ends /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/2003 Time Country Beta Malaysian short sale ban Korean won floats IM F bailout of Indonesia T aiw a n new dollar flo ats

16 India: Daily SW Country Betas & S.E. s B ra zilia n re a l b a n d w id e n s Russian default Country Beta Thai baht floats Korean won floats IMF bailout of Indonesia Taiwan new dollar floats Malaysian short sale ban A sian C risis ends 06/20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/2003 Time

17 Turkey: Daily SW Country Betas & S.E. s Turkish lira crash Banking corruption scandal Asian Crisis ends IMF bailout of Indonesia Russian default Taiwan new dollar floats Malaysian short sale ban Thai baht floats /20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/2003 Time Country Beta Korean won floats Brazilian real band widens

18 Argentina: Daily SW Country Betas & S.E. s S&P rating falls from B+ to B B ra z ilia n re a l b a n d w id e n s Russian default IMF bailout of Indonesia Asian Crisis ends Korean won floats Malaysian short sale ban Thai baht floats Taiwan new dollar floats 06/20/ /20/ /20/ /20/ /20/ /20/ /20/ /20/2003 Time Country Beta Bank runs begin Convertability ends

19 How to Use Rising Country Betas During A Crisis? Global Index Futures The Futures Contract: F t = $100 (Index t strike) The Futures Price: F t = Index t exp(r f D) (T t) The Country-Specific Hedge Ratio is: h kt = β kwt (country portfolio weight) + (bias factor) So, you sell more futures when the country beta rises (unless you were short-selling the country) Problem: October 87 Crash Reason: the Strategy calls for selling more futures when market liquidity may be drying up

20 How to Use Rising Country Betas During A Crisis? Global Index Puts The Put Option Contract: P = $100 max[(strike Index), 0] The Put Price [Merton s formula for options on stocks paying continuous dividends]: P = strike exp(-r f (T t)) N(-d 2 ) Index exp(-d (T t)) N(-d 1 ) The Hedge Ratio from Robert Strong s Portfolio Construction, Management, and Protection is: h Pt = β Pt (Value of Portfolio at t)/(100 strike abs[n(d 1 ) 1]) i.e., buy more put options when, ceteris paribus, the country beta rises.

21 How Do I Put this to Work? I make a strong assumption, in the absence of actual data: there is a liquid secondary market for puts of the same maturity I construct a combined long portfolio of equities and global index puts Π = ( Pt Pt 1 ) ht 1 Put, t Π Vt = ( V V ) t t 1 ( P P ) h ( V V ) Π = π + π = + Hedged, t put, t Vt t t 1 t 1 t t 1

22 A 6-Month Global Index Put Option Hedge: 10/06/97-28/11/97 Profits Equity Portfolio Put O ptions Volatility Related to the October 28, point Decline in the Dow Jones Index 06/11/ /11/ /11/ /11/ /11/ /11/1997 tim e

23 Put Option Prices are Volatile So I m Not Sure About Hedging Robustness Put Option Prices /10/ /10/ /10/ /10/ /10/ /10/1997 tim e

24 Proposal # 2: Quantifying the Risk of Financial Crises With Country Alphas SW Alpha Country Risk-Adjusted Profit SW Alpha S.E. s [I won t have time to explain]

25 China: Daily SW Country Alphas & S.E. s

26 Indonesia: Daily SW Country Alphas & S.E. s

27 Thailand: Daily SW Country Alphas & S.E. s

28 India: Daily SW Country Alphas & S.E. s

29 Turkey: Daily SW Country Alphas & S.E. s

30 Argentina: Daily SW Country Alphas & S.E. s

31 Mexico: Weekly Country Alphas and S.E. s (rolling regression intercept)

32 US: Daily SW Country Alphas & S.E. s

33 Oh Yeah, Remember What Black (1986) Said? I think almost all markets are efficient almost all of the time. Almost All means at least 90%. Well, according to the following graphs I think we can update that to 95%, albeit in a very loose way

34 But Still, These Losses are Huge

35 Pricing the Risk of Financial Crises by Using an Analogy Question: What do Global Investors Do when a Country Experiences a Crisis? One Answer: They Exercise their Options to Exchange that Country s Assets for Investments Elsewhere

36 Good News! We Know how to Price Such Options Margrabe (1978), in the Journal of Finance showed how to price an option to exchange one risky asset for another with a really simple looking formula:

37 How do You Create this Option? You appeal to an arbitrage argument You argue that the one thing (the option) is equivalent to the other thing (the replicating portfolio) Here, the option s price equals the same thing as selling (short) the global index, and buying (going long in) the country index

38 To Demonstrate Empirically How it Works the Trick to Fill In the Blanks These include: the value of the global and country portfolios & and the two cumulative normal distribution function terms &

39 Filling in the Blanks Part 2 We also have to get d 1 and d 2 Margrabe s Version In This Context A Slight Variation Used Here

40 So, how do I get d 1 and d 2? Use for the relative prices/values & Use for the volatilities &

41 Also, You need time to maturity (T t) And just to clarify, the answer to where did come from? is, think regression first and then ask what is the variance of that equation?

42 Q: How do N(d 1 ) and N(d 2 ) Work? A: At Maturity, they re Either 0 or 1

43 Putting All the Pieces Together: Tabular Evidence

44 Putting All the Pieces Together: Visual Evidence for Two-Year Contracts

45 Putting All the Pieces Together: Visual Evidence for Four-Year Contracts

46 Putting All the Pieces Together: Visual Evidence for Six-Year Contracts

47 Putting All the Pieces Together: Visual Evidence for Eight-Year Contracts

48 A Closer Look at Hypothetical, May 20 th, 1994 Contracts for Mexico

49 Suggests Country Betas Largely Drive Global Benchmark Insurance Prices

50 Conclusions With an Asian Crisis risk pricing methodology, hedging may be possible But even if the insurance is too expensive, IMF officials might still find both the rolling country alphas and the formula useful for monitoring global capital flows Future extensions: How about thinking of Currency, Debt or Any Other Crises as Exchange Options?