msci - what if greece leaves the euro june 2015

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WHATIFGREECELEAVESTHEEURO?JUNE2015

WhatIfGreeceLeavestheEuro?StressTestingtheGreekExitScenarioUsingMSCIRiskManager

CarloAcerbi,ZsoltSimon,VivekSridhar,ThomasVerbraken

June2015

IntroductionAsthefinancialpresswondersaboutapotentialGreekexitfromtheeuro,thispaperexaminesapossibleoutcomeforfinancialmarketsbyemployingaGreekExit(Grexit)stresstestusingMSCIRiskManager.1Thisstresstestscenario,aswellasitsoutcomeonselectedexampleportfoliosintheIllustrationsection,demonstratesthepotentialimpactofaGreekexitonthemarketsoutsideGreecebyusingthesocalledRiskManagerspredictivestresstesttool.2Thescenariodesignisbasedonthefollowingguidelines:

Aminimalsetofcorefactorswaschosentospreadtheshockacrossmarkets,illustratingcauseandeffect,notonlycorrelation.

Apropagationofcorefactorshockswasbasedonaregressionperformedinasimilarturbulentperiod,i.e.,theEuropeanSovereignDebtcrisis,fromDecember2011toMay2012.

Therelativemagnitudeofcorefactorshockswasstudiedviaaprincipalcomponentanalysisofthechosenperiod,withafewadditionalshocksadjustedtoaccountforchangesinfactorexposuretoGreecesinceMay2012.

ThispaperoutlinesourrecommendedGreekExittestscenarioaswellasthereasonsbehindthetestingdesign.

TheGreekExitScenarioTheimplicationsforGreeceofaeurodeparture(referredtoasGrexit)illustratedbythehypotheticalstresstestwouldbedramatic.Inthisillustrativescenario,Greecewouldadoptanewcurrency,whichimmediatelyexperiencesaseveredevaluation.Herearethemajorpotentialramificationsofsuchascenariointhisexample:

AllGreekpublicandprivatedebtorswouldbeunderstressastheystruggletorepayeurodenominateddebtwhiletheirincomestreamsaredenominatedintheNewGreekcurrency,potentiallyleadingtodefaultforvirtuallyalloutstandingbonds.

Greekequitieswouldnotbesparedeither.Foraforeigninvestor,thecompoundeffectofthecurrencydevaluationandadropinequitypricescouldleadtomassivelossesonGreekequity.

1Thisisanillustrativescenario,notMSCIspredictionofhowaGreekexitwouldplayout.2RiskManagerhasseveraltoolsforstresstesting.Thepredictivestresstesttoolismeanttodescribethepropagationoftheshocksofalimitednumberofchosenriskfactorsacrosstherestofthemarkets.



TheeffectontheEuropeanandglobaleconomywouldprobablybelimited,astheGreekeconomyissmallrelativetothetotaleurozone.Globalfinancialmarkets,however,wouldexperienceincreasedturbulence.StocksoffinancialinstitutionswithexposuretoGreekdebtlikelywouldsuffer,aswouldequitymarketsingeneralasaflighttoqualityensued.

InEuropeanbondmarkets,yieldsofperipheralcountries(Italy,Spain,Portugal)wouldincreaseduetofearsofcontagion.TheyieldsofGermanBundsandothercorecountrieslikelywoulddrop,againduetoflighttoqualityeffects.Finally,theeurowoulddepreciateasfundswillflowoutofEurope.

DesigningaGreekExit(Grexit)StressTestTwoDesignChoicesTheproposedMSCIRiskManagerstresstestconsistsoftwomajorparts:GreeceandWorldexGreece.TheeffectonGreeceismodeledwithacompositestresstest3thatconsistsof:

AJumptoDefaultstresstestforallGreekbonds,bothsovereignandcorporate Ageneral80%shockonallGreekstocks

FortheWorldexGreecescenario,weuseapredictivestresstest.Tospecifyapredictivestresstest,weneedtodefinethesetofcorefactorsandshockmagnitudes,togetherwiththeestimationwindowandthereturnhorizonusedfortheregression.IntheEuropeexGreecepredictivestresstest,wechosetoshockthefollowingcorefactors:

Italian5Ygovernmentyield:+200bps Portugal5Ygovernmentyield:+200bps German5Ygovernmentyield4:46bps EurostoxxBanksindex:25%

WeusedtheestimationwindowfromDecember1,2011toMay31,2012,andworkedwithweeklyreturns.Inthenextsectionwemotivatethesechoices.

3SeetheRiskMetricsStressTestingGuideformoreinformationonthecompositestresstest.4Thisshockwouldproducenegativerates,asofJune30,2015.Dependingonhowtheinstrumentismodeled(negativeratesallowedornot),thismayleadtointerestratessetwithaminimumlevel.



RationaleBehindtheDesignChoicesEstimationWindowandReturnHorizonWhenmodelingaGreekexitstresstest,weenvisionedashockofamagnitudethattypicallycorrespondstolargerreturnhorizonswithleadlageffectsoftheorderofdays.Therefore,itwasnotadvisabletousedailyreturnsfortheregressionbutlongerreturnhorizonsinstead.Whenthereturnhorizonistoolarge,ontheotherhand,therearetoofewindependentobservationsintheestimationwindow.Hence,weeklyreturnsareanaturalcompromise.Fortheestimationperiod,wewentbacktoearly2012inthedepthsoftheEuropeanSovereigncrisis(sparkedbyGreecesfinancialproblems).TheGreek5YGovernmentyieldpeakedduringthisperiod,ascanbeseeninExhibit1.TheyieldreacheditshighestvalueattheendofMay2012,whichistheendofourestimationwindow.TheCDSmarketofGreeksovereigndebtfroze(CDSquotesstopped)inMarch2012whenGreecerestructureditsgovernmentdebtheldbyprivatecreditors.DuetothecomovementbetweenthegovernmentyieldandthesovereignCDSspreadandduetothelimitedliquidityoftheCDSduringthecrisisperiod,wedecidedtouseperipheralyieldsinsteadofperipheralCDSspreadsinthedefinitionofthestresstest.Forthestartoftheestimationwindow,welookedattheevolutionofcorrelationsthroughoutthecrisisperiod,asshowninExhibit2.Wewantedrelativelystablecorrelationsthroughouttheestimationwindow.TherewasashiftinmanycorrelationsaroundDecember2011,whichiswhywechosethatpointasthestartoftheestimationwindow.



Exhibit1:Greece5YGovernmentYieldandtheCDSSpreadoftheGreekGovernment

Source:Reuters,CMA,Markit.

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GreeceGovernmentPostExchangeBenchmarkZeroCMAGreece(Senior,CR03)CDSMarkitHellenicRep(SNRFOR,CR)CDS



Exhibit2:RollingCorrelationofItalian5YGovernmentYieldwithotherEuropeanYields

Source:Correlationswerecalculatedbasedon5YgovernmentyielddatafromReuters.

CoreFactorSelectionThedefaultofGreekgovernmentandcorporatedebtwouldcauseperipheralyieldstospikeduetofearofcontagion.TheconsequentflighttoqualitymaypotentiallyleadtotighteningGermanyieldsandaweakeningeuro.,ThestockpriceofbanksthatareexposedtoGreekdebtwouldalsobeunderpressure.Theaimofourtestwastomodelthoseeffectswithalimitednumberofcorefactors,whicharethenpropagatedtootherriskfactorswiththepredictivestresstest.WerepresentedtheyieldsofperipheralEUcountriesbytheItalian5YGovernmentyield,whichisingeneralcorrelatedwithotherperipheralcountriesyields(seeExhibit3).ThecorrelationwithSpain,theotherlargeperipheralEUeconomy,wasespeciallyhigh.Tocapturethechangeofthecorecountriesyields,weincludedtheGerman5Yyield.Finally,weshockedtheEurostoxxBanksIndextomodelthenegativereturnofthefinancialstocks.

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1 GermanGovernmentDebtBenchmarkZeroCouponSpanishGovernmentDebtBenchmarkZeroCouponFrenchGovernmentBenchmarkZero

GreeceGovernmentPostExchangeBenchmarkZeroHungarianGovernmentDebtBenchmarkZeroCouponIrishGovernmentDebtBenchmarkZeroCouponItalianGovernmentBenchmarkZero

PolishGovernmentDebtBenchmarkZeroCouponPortugueseGovernmentDebtBenchmarkZeroCoupon



Exhibit3:CorrelationBetweenEuropeanYields

Source:Correlationswerecalculatedbasedon5YgovernmentyielddatafromReutersbetween[date]and[date].MagnitudeofShocks:NoEuropeanCatastropheAccordingtoouranalysis,theseverityofcontagionthroughtheeurozoneperipheralcountrieswaslesspronouncedthanin2012whentheprevioussovereigndebtcrisisoccurred.Thereason:Portugal,Italy,SpainandIrelandmadeimportantstepsinthelastthreeyearstobuildmorestableeconomiesandtominimizetheimpactofafuturecrisis.Exhibit4showsthehistoryofthebetaofEuropeangovernmentyieldscomparedtotheGreekgovernmentyield.Notethatin2015theGreekbetashavebeenmuchlowerthantheywereinpreviousyears.ThedirectionoftheshocktotheGermanyieldandtotheEuropeanbankingstocksisderivedfromaprincipalcomponentanalysis(PCA)performedonthecorrelationmatrixofweeklyriskfactorreturnsovertheestimationperiod,asthefirstprincipalcomponentgavethemostplausibledirectionofashock.ThecorrelationbetweenaselectedsetofriskfactorsisshowninExhibit5,whereastheoutcomeoftheprincipalcomponentanalysisisshowninExhibit6.Thecorrelationduringtheestimationwindowwasasweenvisionedinourstresstest,i.e.,iftheItalianyieldincreases,thentheeurowoulddepreciate,equitywoulddrop(especiallythebankingsector),theGermangovernmentyieldwoulddecreaseandperipheralgovernmentyieldswouldincrease.5Thefirstprincipalcomponentshowedthesamedirectionofshocksonthecorefactors.Hence,wemodeledtheGrexitscenariobyusingtheabovementionedestimationwindowfromDecember1,2011toMay31,2012andappliedashockinthedirectionofthefirstprincipalcomponent.WesettheItalian5Ygovernmentyieldshockat+200bps,andshockedtheGerman5Ygovernmentyieldaccordingtothedirectionofthefirstprincipalcomponent.AstheItalianyieldincreasedby200bpsoverthelastthreemonthsoftheestimationperiod,wethinkthatthisshocksizeisreasonable.FortheEurostoxxBanksindex,wedidnottakethemagnitudeassuggestedbythePCA,butwescaledtheshockdown,basedonthecurrentlylowercorrelationwiththeItalian5Yyield.Thereason:backin2012,banksweremuchmoreexposedtoGreekgovernmentdebt,whiletodaygovernmentshavetakenovermuchofthisdebt.

5Thiswastheresultofthespecificchoicewemadefortheriskfactorsandtestperiod.Differentchoicesmayyieldmateriallydifferentresults.

GermanGovt5Y

SpanishGovt5Y

FrenchGovt5Y

GreeceGovt5Y

HungarianGovt5Y

IrishGovt5Y

ItalianGovt5Y

PolishGovt5Y

PortugueseGovt5Y

GermanGovt5Y 1.00SpanishGovt5Y 0.03 1.00FrenchGovt5Y 0.24 0.47 1.00GreeceGovt5Y 0.24 0.35 0.12 1.00HungarianGovt5Y 0.25 0.24 0.31 0.20 1.00IrishGovt5Y 0.11 0.44 0.19 0.40 0.18 1.00ItalianGovt5Y 0.21 0.69 0.41 0.21 0.26 0.40 1.00PolishGovt5Y 0.13 0.45 0.30 0.24 0.45 0.32 0.54 1.00PortugueseGovt5Y 0.18 0.22 0.01 0.07 0.13 0.09 0.12 0.00 1.00



Exhibit4:Rollingbetaof5YEuropeanGovernmentYieldstothe5YGreekGovernmentYield

Source:betaswerecalculatedbasedon5YgovernmentyielddatafromReuters.Exhibit5:CorrelationBetweenSelectRiskFactors

Exhibit6:PrincipalComponentAnalysis.

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GermanGovt5Y SpanishGovt5Y FrenchGovt5YGreekGovt5Y HungarianGovt5Y IrishGovt5Y

RiskFactor Vol CorrelationEuro 1.26 1.00 0.50 0.57 0.38 0.36 0.17 0.38 0.04EUROSTOXX50Index 2.59 0.50 1.00 0.86 0.63 0.32 0.26 0.55 0.07EUROSTOXXBanksIndex 5.59 0.57 0.86 1.00 0.60 0.42 0.18 0.67 0.06DEMGovt60M 0.10 0.38 0.63 0.60 1.00 0.03 0.24 0.21 0.18ESPGovt60M 0.34 0.36 0.32 0.42 0.03 1.00 0.35 0.69 0.22GRDGovt60M 1.85 0.17 0.26 0.18 0.24 0.35 1.00 0.21 0.07ITLGovt60M 0.35 0.38 0.55 0.67 0.21 0.69 0.21 1.00 0.12PTEGovt60M 1.79 0.04 0.07 0.06 0.18 0.22 0.07 0.12 1.00

RiskFactor PC1 PC2 PC3 PC4 PC5 PC6 PC7 PC8Euro 0.36 0.07 0.13 0.03 0.90 0.02 0.18 0.07EUROSTOXX50Index 0.46 0.20 0.03 0.16 0.21 0.55 0.23 0.56EUROSTOXXBanksIndex 0.48 0.13 0.19 0.10 0.16 0.23 0.07 0.79DEMGovt60M 0.33 0.47 0.25 0.33 0.09 0.69 0.11 0.08ESPGovt60M 0.32 0.53 0.06 0.34 0.02 0.29 0.64 0.05GRDGovt60M 0.21 0.18 0.90 0.18 0.02 0.17 0.19 0.10ITLGovt60M 0.41 0.30 0.26 0.17 0.33 0.23 0.67 0.18PTEGovt60M 0.00 0.56 0.05 0.82 0.07 0.01 0.02 0.02

PCvol 1.89 1.22 0.96 0.88 0.78 0.53 0.47 0.33PercExpl 45 19 11 10 8 4 3 1



AsecondimportantobservationisthatthePortuguese5Yyieldwasnotshockedinthefirstprincipalcomponent,mostlikelyduetoidiosyncraticeventsaffectingPortugalduringtheestimationwindow.InordertoproperlycapturethepotentialcontagioneffectonPortugal,weaddPortugal5Ygovernmentyieldtooasacorefactorandshockitby200bps.Insummary,weproposedthefollowingshocksinourtest:

Italian5Ygovernmentyield:+200bps Portugal5Ygovernmentyield:+200bps German5Ygovernmentyield:46bps EurostoxxBanksindex:25%

Inthenextsectionweapplythestresstesttotwosampleportfolios.

IllustrationToillustratethisproposedstresstest,weappliedourGreekexitscenariotoasampleportfolioreplicatingtheMSCIACWIIndex100%andtoasampleportfolioconsistingofgovernmentbondswithamaturityof10years.ThepredictedreturnaswellasthestandarderrorarebrokendownbycountryandareshowninExhibit7.Fortheequityindexbasedportfolio,weseeanegativereturnforallcountries,wherebytheseverityofthedropdependsontheproximitytoGreece,e.g.,Spain(aperipheralcountry)andAustria(whoselargestcompaniesarebanks)experiencerelativelylargedrops.AlsonotethattheGreekequitydrops80%inpriceand,sinceitisnotpartofthepredictivestresstest,thereisnostandarderrorforGreece.Whilethegovernmentbondsinperipheralcountrieswouldexperienceadropinvalueinthisillustration,corecountries,suchasGermanyandtheNetherlands,wouldgainvalue,aswellasothercountriesoutsidetheeurozone(e.g.,theU.S.,GreatBritain),whichgenerallybenefitfromflighttoqualityeffects.Greeceitselfwouldexperiencedefaultacrosstheboard.NotetheimplicationsforPortuguese,ItalianandCypriotdebt:

ThepricedeclineinthePortuguesebondismuchlessthanthepricedeclineintheItalianbond,eventhoughboth5Ygovernmentyieldshavebeenshockedwith200bps.Thisismainlycausedbythedifferentbetaoftherespective10Ygovernmentyieldstothe5Yyield.ForItaly,thebetaofthe10Yyieldtothe5Yyieldis0.70,whereasforPortugalthisisonly0.33.Asaresult,thePortuguese10yearbondsuffersless.

ThereisanextremepredictedreturnwithlargestandarderrorforCypriotdebt.ThereasonisthatCypruswassufferingitsownfinancialcrisisin2012andweshouldnotextrapolatefromthatperiod.Instead,forportfolioscontainingCypriotassets,wemaywanttoaddanadditionalcorefactorforCyprusorstressthoseassetsinadifferentway.

Thesetwoexamplesillustratethatoneshouldexercisecarewithstresstests,especiallywhenusingpredictivestresstesting.Itmaybenecessarytocustomizethestresstestforindividualusecases.



Exhibit7:StressTestResultsforMSCIACWIandaSampleGovernmentBondPortfolio.

ConclusionAstheGreekdebtcrisisdrivesapotentialexitfromtheeuro,weproposeaRiskManagerstresstesttomodeltheimpactofaGreekexitscenarioonfinancialassets.GiventhedifferentscenarioimplicationsonGreeceversustheWorldexGreece,wedesignedtwodifferentstresstests.OurtestsassumesthatinGreece,equitywouldsufferheavily,andvirtuallyallbondsdefault.TheimpactonEuropeandtheworldwouldbecausedbyfearofcontagionandasubsequentflighttoquality.Theseeffectsledtowideningperipheralyields,tighteningcorecountryyields,aweakeningeuroandadownwardpressureonequity,inparticularfinancialstocks.However,thetestresultsindicatedthattheimpactwouldnotbedevastatingfortheeurozone.

MSCIAWCI(selectcountries) BondportfolioCountry deltaPV deltaPVSE Country deltaPV deltaPVSEAT 20.9% 1.4% AT 0.5% 0.7%AU 2.3% 1.1% BE 2.5% 0.8%BE 9.9% 1.0% CY 22.0% 17.9%CZ 9.2% 1.2% DE 4.9% 0.2%DE 10.2% 1.1% ES 7.4% 1.0%DK 7.7% 1.2% FI 3.8% 0.3%ES 14.0% 0.9% FR 0.3% 0.6%FI 11.2% 1.6% GB 5.3% 0.5%FR 10.7% 1.0% GR 20.4%GB 6.6% 1.0% IE 2.3% 0.8%GR 80.0% IT 11.5% 0.5%HU 18.4% 2.4% JP 7.2% 0.9%IE 7.9% 1.1% LT 3.6% 0.7%IT 18.6% 0.8% LU 2.9% 0.2%JP 0.5% 0.9% LV 1.3% 0.7%LU 7.6% 0.9% MT 0.1% 0.2%MT 3.5% 1.8% NL 4.8% 0.4%NL 6.8% 0.9% PT 5.7% 1.4%NO 7.8% 1.3% SI 4.5% 1.0%NZ 2.1% 1.0% SK 0.3% 0.7%PH 6.1% 1.6% US 7.7% 0.7%PL 11.0% 1.3%PT 11.4% 1.7%SE 11.9% 1.5%US 2.6% 1.0%TotalACWI 4.1% 0.9%

AMERICASAmericas 18885884567*Atlanta +14045513212Boston +16175320920Chicago +13126750545Monterrey +528112534020NewYork +12128043901SanFrancisco +14158368800SaoPaulo +551137061360Toronto +14166281007EUROPE,MIDDLEEAST&AFRICACapeTown +27216730100Frankfurt +496913385900Geneva +41228179777London +442076182222Milan +390258490415Paris 0800915917*ASIAPACIFICChinaNorth 108008521032*ChinaSouth 108001521032*HongKong +85228449333Mumbai +912267849160Seoul 0079885213392*Singapore 8008523749*Sydney +61290339333Taipei 00801127513*Thailand 0018001562077181*Tokyo +81352901555

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msci - what if greece leaves the euro june 2015

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