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Rating Agencies Unfairly Give Turkey Short Shrift

:)))

Rating Agencies Unfairly Give Turkey Short Shrift

The markets don't necessarily "listen" to rating agencies either which is a good thing. But still there is an apprehension to reduce General Electrics's AAA rating (which is totally undeserved by the way), because there are other consequences of reducing debt grade as well. So why don't we all pretend that the emperor has clothes on as long as we can.

As far as Turkish sovereign debt is concerned, it has in the past been priced a lot better than its official grade, which is a clue as to how little rating agencies are valued in the markets. However, there are other issues here that have to do with various regulations (a lot of buy-side funds are simply not allowed to buy below investment grade instruments, for instance), and Basel II capital requirements that create valid concerns for borrowers that are ranked below invesment grade. That rating agencies fail miserably in this job and create uneven grounds for borrowers is another reason for my "outrage" as well.

In regards to my decision to buy a medium duration eurobond, of course spreads may widen given the uncertainties and the global crisis, but I generally tend to believe that analyst expectations lag the actual events, meaning that they are most of the time behind the curve. So the fact that I'm NOW hearing so much doom and gloom regarding Turkish economy is more of a bullish indicator for me. Also from my perspective I'm just locking in a yield. If an American feels the US treasury is unable to default, why would a Turkish person feel differently especially given the fact that the Turkish treasury has never defaulted in its history?

Of course there is more of a fight with people's perceptions here: Cliches, stereotypes that are hundreds of years old. You are never going to convince a biased person who has already made up his/her mind. On the other hand, if investors end up losing all their investment because they trusted the AAA rating of a country which turned out to be miserably wrong, then there is something quite alarming and uneven going on in here, and it's more than the good old injustices of life.

Also, I've generally had it with all the "boo!" I'm hearing in general about certain great American companies that actually produce something and add real value to society. But they get pulled down with the financial firms that in the end produce nothing. Yes, this is a financial crisis that also has consequences in the real economy, but let's try to separate the good from the bad.

Defending VAR - But You Still Need Common Sense

Mr. Heath - thank you for eloquently explaining the Goldman episode in the framework of testing a hypothesis.

morph366 - I'm not saying that the quants are misunderstood. I'm saying a lot more than that.

I'm saying that the quants, or more specifically quantitative models, are used as whipping boys in what turns out to be a great lapse in plain old business ethics. It is not the self-serving "quant" rhetoric that I am concerned with, but very much the other way around.

It is rather the self-serving justifications of the failed Wall Street management that concerns me. Titanic was sinking, and its captains skillfully escaped the ship first, while pocketing large bonuses and leaving the rest of the passengers (the American taxpayers) on board. What was the music played by the orchestra? The now famous our-VAR-models-didn't-... tune.

I must admit that the massive PR campaign that so successfully packaged the blame onto quantitative models, as well as the sensationalism offered by Taleb make all of this a lot easier to swallow.

This is not a "protest" piece as it is a piece that aims to give a background on value at risk and hopefully show people how to think about it. I for one use the concept (loosely) in my simple stock portfolio allocation to have an idea on what I can expect to lose, 95% of the time, 99% of the time, or 99.9% of the time. You would be surprised at how well it does, especially if you adjust your variables or data depending on how markets change. Of course, that's also a form of ART as much as investing is.

As I've tried to portray, VAR works a lot better (and is much easier compute) for simple portfolios that take no derivatives positions (especially with assymetric payoffs) or leverage. No, VAR will not save the world. Yes it can be wrong depending on how markets change. Yes you can come up with different values of VAR depending on your assumptions about markets. Yes it requires a human being to interpret the number. And NO it is not acceptable to blame VAR for your losses when things turn sour.

Defending VAR - But You Still Need Common Sense

Dear Mr. "cr0bar",

I started college with the full intention of a career in physics, including a doctoral degree. I majored in physics and then also in economics with an eye toward getting employment on Wall Street. I graduated Magna Cum Laude, and with that my Physics GPA was considerably higher than my economics one. I never moved on to graduate level, but I can show you official records of advanced undergraduate courses in physics that I took.

Employers on Wall Street did NOT think that I was talking mumbo-jumbo whenever I drew similarities with physics. In fact, I was given more quantitative roles than I may have asked for simply because of my background.

My background as well as experiences are available to anybody who wishes to conduct research, because I'm actually blogging under my real name.

If you wish to accuse people of trying to "intentionally deceive" others, you would enhance your credibility if you left comments with your real identity.

Defending VAR - But You Still Need Common Sense

"This is a black and white issue, if the models are wrong they are wrong, not a little bit right."

A little quantum mechanics will teach everyone about black and white. Is light a particle or a wave? What about the uncertainty principle? What about electron spin?

Okay, I won't plead my case with physics, but practitioners of models know that mathematics is not going to have the same success at describing markets (human behavior) as the success it has had in describing the laws of nature.

This is old news, and not a novel realization that Taleb currently seems to hold a monopoly on. Unfortunately the point seems to escape those who like the sensationalism that Taleb offers.

The point of the article in one sentence is:

The hysterical fingerpointing on mathematical models ironically relieves responsibility from those very human beings who should be held accountable for what went wrong.

Calculating Country Risk Observed by Betas

The model as it is applied assumes exposure to currency risk, but it does not measure it. This is because I regressed the U.S. dollar returns of these countries to the global index, and did not include a currency variable to control for that risk.

Note that this kind of practice builds even more assumptions into the model, such as the assumption that the PPP and uncovered interest rate parity conditions hold and that investors are indifferent between domestic and foreign assets and do not demand a currency risk premium (which is rarely the case).

The model specification assumes that all markets are perfectly integrated into the world markets and there are no constraints to invest into any of the markets. Note that multi-factor models and conditional regressions such as usage of GARCH could account for these conditions but they would not give the kind of simple one-shot picture I was looking for.

Again, it could be argued that the model is incorrectly specified because it does not take into consideration many of the factors that are relevant. However I had two very simple questions, which is why I chose to go with one-factor ICAPM:

1) Which stock markets present the most significant day-trading risk?
2) How do these markets move up and down with respect to the global market in a single trading day?

Calculating Country Risk Observed by Betas

Mr. Chris B, thank you very much for the positive criticism and encouragment. That means a lot, I really appreciate it.

Calculating Country Risk Observed by Betas

Mr. Huebert,

I used to make a living producing and publishing quantitative models, tables / information for sell-side research. Developing proprietary models remains one of my areas of expertise. There are people who value this kind of information because they know exactly how to (or how not to) interpret them.

This is part of a much bigger risk management project that I'm consulting on. I thought it would be interesting to publish some of my findings. A lot of detail is given precisely because some people (such as commenters above) have doubted the accuracy of the measurements such as correlations.

This is precisely why a lot of detail is given. It is the nature of such quantitative work. I generally do not provide recipes for many models that I design because by their nature they are proprietary. However what I've done above is a very straightforward exercise for many experts in the field of computational finance and I thought publishing my findings would be an interesting real-world test for the CAPM model.

That having been said, I do not provide investment advice through Seeking Alpha medium nor do I market my services as such. This should be clear to many readers of my work. Thus I have made it clear that none of the above should be interpreted as an investment recommendation in any way.

Calculating Country Risk Observed by Betas

Mr. Flash Gordon, please be advised that while the ten-year correlation with respect to Czech Republic is relatively low at 0.45 placing the beta at 0.83, the two-year correlation presented in the two-year table has increased to 0.65, placing the beta at a more risky 1.14. This already verifies your observation that the Czech Republic remains a moderately risky market in terms of its systematic risk. Thanks.

Calculating Country Risk Observed by Betas

If I run these regressions on the past 6 months of data I'm confident that I will get significantly higher correlations. That's a good idea for another writeup. I will actually run the numbers and publish what I get.

However that's the nature of the beast when it comes to diversification. It does work surprisingly well most of the time until it doesn't, especially when you need it the most.

A powerful market crash as the current one is one such example. Every country got affected, even those that show the lowest betas.

Calculating Country Risk Observed by Betas

Beta measures the systematic risk of the security with respect to the market, and by its nature it is not diversifiable with another long security position. This means that a high beta security is more risky than a low beta one. What CAPM infers is that Germany and England have more systematic risk than Egypt and Morocco. This means that you will have more exposure to "market risk" if you are long England, and even more so if you are long Brazil.

There ARE ways of making portfolios beta neutral and you may indeed protect yourself from the general market swings by hedging yourself with futures positions or in some other fashion. The reason why I'm saying this is that you mention that a stock (or country) may have a high beta but it may still perform better at the end of the time frame. If that's the case you have captured that illusive alpha. This is a possibility but not always the case with all high beta stocks (or countries).

I hope this clarifies why I feel somewhat excited about Egypt and Morocco and several other emerging markets in Asia as a result of this study. By owning them, you will NOT gain a heavy exposure to "market risk", but you will still carry the unsystematic risks associated with these individual markets. Hopefully those unsystematic risks you carry are risks to the upside.

The point of the beta measurement is that it gives you a way of measuring your exposure to market risk by the virtue of owning a certain stock (or country). If I'm already long various markets, for instance, why do I add on the extra risk of Brazil if I'm not sure whether Brazil carries an alpha, or the ability to outperform the rest of the world?

Even if Brazil carried an alpha, by owning the country I would in essence be leveraging my long position if I'm already long the U.K., for instance. If I'm a hedge fund I have the option of getting rid of the total global beta of my position via various short futures positions or by shorting likewise beta markets, but you can imagine that all this is getting fairly sophisticated in terms of computational capabilities and beyond the realm of the ordinary investor like you and me. Not to mention that these types of "market neutral" positions have been shown to be not so market neutral when betas shift or when unexpected events occur under the category of "unsystematic risks".

To make the long story short, I do believe that beta is a fairly good way of measuring risks, at least among what's available to us. It does NOT, however, tell us whether a security or country is going to have successful performance or not.

Turkish Central Bank Surprises Everyone with Interest Rate Decision

Thank you for the comments. There are quite a few points above that need to be taken very seriously - possibly requiring full blown articles (or more) in order for me to address them in a fair fashion. I will do so in a following write-up.

Foreign Investors Waking Up To Turkey?

Looking back to the article, the part where I talk about interest rate parity conditions sounds misleading. I should have explained myself better:

The forward currency prices observed in the market reflects the interest rate differential between two currencies. In the case of Turkish Lira, the forward price is always quoted at a discount to the current exchange rate, because the interest rate for the home currency (Turkish Lira) is always greater than the interest rate for the foreign currency (dollar or Euro).

So if someone wishes to either hedge or take a position, specifically a short position in the Turkish Lira via dealing in the futures market, they will have to take the forward discount into consideration. Given that the Turkish Lira has actually strengthened in the past due to high interest rates as opposed to weakening, taking a position in the futures markets has been a questionable trade especially on the short side.

There's no violation in the strict theoretical price but the theoretical price in terms of forward discount never actually got realized in the past till expiration due to the strengthening effect of the high interest rate, which is the opposite of the effect that's observed in the TL forward prices due to the covered interest rate parity condition.

Turkish Shareholders Association Plans to Sue the Turkish Central Bank

You are saying that the export-oriented growth models are no longer working for Germany and Japan, but the fact of the matter is that's how they once GREW from being small economic players to two of the world's most significant economic powers. So while an export-oriented growth model could not help these countries grow indefinitely because they cannot keep exporting more products to Mars, for instance, it helped them establish themselves as major players in the global economic scene.

The relatively bloated Japan and Germany of today experience quite different dynamics from the once lean and mean export-oriented machines they were. Turkey first needs to register some significant growth similar to the Asian tigers, for instance, before we can ignore or snub an export-oriented growth model for the country. An export oriented model has been the norm for every other country that has experienced successful development, without depending upon much bigger and richer countries to "digest" their economies.

Note: By those countries I'm referring to some of the "little" countries that joined the European Union and were economically and socially "digested" by it, for better or worse. But those countries house a lot smaller populations than a 70-75 million strong Turkey. So even if I ignore all the usual European hypocrisy associated with Turkey's accession process, I cannot ignore the fact that it is quite difficult for Europe to digest a country like Turkey. So I need to be realistic in my hopes for attainable growth for Turkey, and it's not going to be because Europe will welcome the country with open arms, which it won't.

ALL of the countries in the Gulf and hence ALL investments in that region benefit from a spectacular performance of oil. It's a spillover effect from the good performance of a key component of their markets. But fundamentally speaking, the incredible amounts of cash that piled up as a result of selling oil to the rest of the world HAS been put into excellent use in other ways - We know the success stories of various financial and economic centers in that region but they depended on the successful oil exports to get started. Of course I'm not trying to belittle some of the great performance in the region, but it's always good to know why something has been successful so it can be repeated in the future. Turkey CAN benefit from the successful economies in the Gulf and offer goods and services to the region, but that's still called being export-oriented as far as I'm concerned.

Sure Turkey can attract investment from those Gulf countries and elsewhere. There is an argument to be made that when Turkey attracts foreign investment, growth can be achieved. But Turkey has had difficulty in attracting direct foreign investments and most of the money that has been attracted to the country came to buy "existing" firms and businesses as opposed to creating new businesses or new jobs. That's not growth, it's called saving the day by finding stuff in the attic to sell to finance a growing trade deficit.

Exports did register respectable growth if you completely disregard the incredible growth in the country's imports. It's the NET exports or the trade deficit that matters. Using selective data to publish some impressive growth in exports does not provide the whole picture and is not the right way to analyze any economy or investment. Seems like you've read too much AKP "talking points" and too much of the "bullet points" of those financial analysts who tout - and benefit from touting - the economic "successes" of the AKP government.

However, I don't disagree with the view that Turkey offers, or may offer, a very good growth potential. In fact, the manufacturers, exporters, i.e., all the guys who actually drive the engine of growth are doing a spectacular job given how truly hostile the environment is to new investments and entrepreneurial activities. Who in their right mind would continue operating a factory or run a business if they can receive an annual rate of risk-free 22%, or need to borrow at that rate? Of course what does happen is that they may borrow in currencies that are a lot cheaper to borrow, thus engaging in some sort of a "carry trade" to finance a business.

So one of the end results of this type of an economic "program" is that you create firms who are completely dependent on cheaply financed money in "cheap" foreign currency whose overall debt in other currencies has grown threefold since 2002. This is A growth model, I guess, but one that depends on the continuation of high interest rate policies along with an expensive Turkish Lira but carries risks when and if these policies are reversed or forced to reverse by market forces, or the way AKP likes to put it, by some "elitist" or "unashamed" Kemalists.

Turkish Shareholders Association Plans to Sue the Turkish Central Bank

Correction: Turkey gets slammed because of increase in energy prices as an IMPORTER of oil.