Evaluating Market Risk Factors in Positive and Negative World Markets

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Evaluating Market Risk Factors in Positive and
Negative World Markets

• Buhdy Bok
• Frank Liu
• Jeff Lu
• Brad Newcomer
• Ron Yee

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Agenda

• Hypothesis
• Overview
• Analysis
• Applications
• Next Steps

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Hypothesis

• Country market risk differ depending upon market
  conditions
• Skewness is an important factor in evaluating
  country market risk

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Overview

• CAPM assumes an average beta
• Volatility varies in different market conditions
• Betas vary depending upon market conditions
• CAPM assumes returns are normally distributed
• Returns are not generally symmetrical
• Returns typically exhibit positive or negative
  skewness

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Data Source

• Compared Monthly Returns - Equity Markets from 37
  Countries vs. World Market (MSCI Indices)
• 16 Developed Nations
• 21 Emerging Markets

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Diversion from Standard CAPM

• We want to split the CAPM Beta into 2 Betas
• Beta when world market return is positive
• Beta- when world market return is negative
• r     a     ß( Rm - Rf ) error
• to
• r     a     ß( Rm - Rf )   ß-( Rm- - Rf
  ) error

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Coskewness Regression

• Coskewness The amount of skewness that an asset
  adds to the diversified portfolio (systematic
  skewness)
• r     a     ß1( RM ) ß2( RM )2 error

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Application of the Model

• Results demonstrate the significance of separate
  betas for up/down markets
• A simple, intuitive refinement of the CAPM
• Incorporating this concept into tactical
  allocation decisions will generate excess returns

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Application of the Model

• Requires a predictive model to forecast up/down
  markets
• New procedure
• Create a predictive model to forecast /- market
  signals
• Calculate the appropriate correlation matrix
• Run optimization model (either up/down)
• Use output to determine asset allocations

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Application of the Model
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Application of the Model
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Next Steps

• Run an out-of-sample test of the model
• Parse market risk over more buckets
• Examine performance of market risk factor using
  different parsing criteria
• e.g., recession vs. expansion
• Goal create a more accurate pricing model that
  allows the market risk factor to be more dynamic
  over a range of market conditions