Suna Reyent

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.