Optimal Investment Theory Asset Allocation…didattica.unibocconi.it/mypage/dwload.php?nomefile=Delitalia_prese… · 720bp spread in the 2Y BTP-Schatz yields reached in November

Exceptional circumstances

2

Optimal Investment Theory

… in a distorted environment

Asset Allocation…

33 13 November 2014 Pictet Asset Management

Abstract The current intra-EMU Sovereign spreads no longer represent a pure credit differential, but they

incorporate a systemic risk of EMU break-up: call it extra default risk (if after break-up ‘weak’

countries were to keep their debt in €), or ‘devaluation’ risk if, as we would expect, when and if

countries convert their debt into the new national currency upon leaving EMU.

The probability of currency split is now perceived to be ‘non negligible’. In such scenario,

fundamental arguments (Unit Labor Cost trends…) argue in favor of an appreciation of the German

currency against the other large EMU members by around 30%.

All this means that the portion of the spread controlled by a single country is now limited: for Italy’s

720bp spread in the 2Y BTP-Schatz yields reached in November 2011, only around 120bp may be

considered a ‘true’ credit risk (based on a regression analysis which takes into account the relative

budget & debt relative fundamentals of the two countries: Italy & Germany).

The other part (up to 600bp) could be ascribed to market skepticism about EMU Countries staying

together in a viable way. Hence, discussing a revision of the Lisbon Treaty, a Greek exit, or any

other element raising the market perception of the general EMU break-up risk puts a prevailing

upward pressure on the spread irrespectively to Italy’s fiscal performance.

This new risk factor, however, may well trigger the infamous ‘debtor trap’ (risk premiums requiring a

higher budget surplus which harms growth hence solvency, which in turns means ever higher risk

premiums), which is exactly what we witnessed in the past months.

A circuit breaker was required to counter these systemic factors: the analysis legitimizes the ECB

(only entity with sufficient b/s ammunition) restoring Financial Stability. Such circuit breaker finally

arrived in the summer of 2012 with the ESM (European Stability Mechanism) complemented by

the ECB’s OMT (outright Monetary Transaction) a mechanism that allows the Bank to buy Bonds.


EMU trasformed into a marriage of dis-interest!

10Y YTM of main EMU Countries: combination of Systemic and Country-specific patterns (for Programme Countries: Greece, Portugal, Ireland)

Fx flexibility and seignorage lost; yields at pre-EMU levels: € costs outweight the advantages ?

Source: Pictet, Bloomberg

1,5

1,5


Perception on G3 Solvibility

5Y CDS of the US, JAPAN and GDP weighted average od 5Y CDS of EMU (ex-Greece) Countries

EMU pays an unwarranted premium relative to its pubic finance fundamentals


USA

66bp

46bp

18bp

EMU

Japan

years 2012 2013 2014 2015 2012 2013 2014 2015USA -9,2 -6,2 -5,4 -4,7 102,4 104,5 105,9 105,4Euro Area -3,7 -3,0 -2,5 -2,3 92,7 95,0 96,0 95,4Germany 0,1 0,0 0,0 -0,1 81,0 78,4 76,0 73,6Italy -3,0 -3,0 -2,6 -2,2 127,0 132,6 135,2 133,9Japan -8,7 -9,0 -7,4 -6,2 237,3 244,0 243,7 244,1

European Commmission (Spring Forecast - May 2014)

Deficit (% GDP) Debt (% GDP)

Reasons behind EMU pain


The uncomfortable EMU apartment block

In the EMU house the Greek fire

started 3 years ago. The lack of

windows (floating currencies) makes

suffucation more likely, but does not

explain why the fire spreaded so

rapidly…

Economists (eg De Grauwe) pointed

out poor Governance. Yet I believe

market forces and poor decision making have been underestimated

Congenital deficiencies? Mostly market circularity and many mistakes (PSI, EBA...)


Distrust with €: game changer for Sovereign Solvency

10Y Asset Swap spread (BTP-Bund): Credit premium of BTP vs Bund = (YTM BTP 10Y – ITL Swap 10Y) – (YTM Bund – DEM Swap 10Y)

Asset swaps used to measure the relative Credit Premiums: Italian case

Source: Bloomberg

550bp

>400bp

<150bp

Sovereign bond spreads back to pre-EMU era!

10Y Swap spread (ITL-DEM) = risk free rates in respective

Currencies embed the devaluation risk

of the ITL vs DEM (covered parity)

Asset Swap difference

10Y BTP-Bund


Main reason for BTP-Bund is the Uncovered Parity

The risk premium (CRP) depends on the expected probability of default: YTM BTP * (1- Pr[default]) = Risk Free Rate CRP BTP = YTM BTP – Risk Free Rate = YTM BTP * (Pr[default])

The credit premium between Italy and Germany was measured as: CRP (ITA-GER) = (YTM BTP 10Y – ITL Swap 10Y) – (YTM Bund 10Y – DEM Swap 10Y) Where Swaps enjoyed a AAA Rating (anyway the same Rating in ITL and in DEM)

CRP (ITA-GER) = (YTM BTP 10Y – YTM Bund 10Y) – (ITL Swap 10Y – DEM Swap 10Y) With reference to the Uncovered Parity: (ITL Swap 10Y – DEM Swap 10Y) = E[Δ% (ITL/DEM)] Hence: CRP = (YTM BTP 10Y – YTM Bund 10Y) – E[Δ% (ITL/DEM)] Which leads to: (YTM BTP 10Y– YTM Bund 10Y) = CRP (ITA-GER) + E[Δ% (ITA/GER)] * Pr[€ break-up] Pr[€ break-up] could be interpreted as a CONVERSION RISK in case of EMU break-up or DEFAULT following the NON-CONVERSION in case of Italy exiting EMU (the latter ought to be reflected into CDS spreads, while not the former as CDS do not trigger if a G7 Country changes legal tender (and its securities are reinbursed in such cncy).

With the ITL (Italian Lira),

its devaluation expectations

were embedded in the risk-

free (swap) rate differential

Today the devaluation risk is ‘incorporated’ into the BTP-Bund spread


BTP-Bund definitely includes EMU Reversibility Risk

12 Oct 14


10Y BTP-Bund Spread = Credit Premium + Expected Realignment x Probability of Fluctuation

YTM 10Y BTP

0,83%

Spread 10Y BTP vs Bund

150bp

YTM Bund 2,33%


Source: Pictet

-0,5

0,0

0,5

1,0

1,5

2,0

2,5

Q3

1993

Q3

1994

Q3

1995

Q3

1996

Q3

1997

Q3

1998

Q3

1999

Q3

2000

Q3

2001

Q3

2002

Q3

2003

Q3

2004

Q3

2005

Q3

2006

Q3

2007

Q3

2008

Q3

2009

Q3

2010

Q3

2011

Actual

Fitted

120bp

R2= 0,35

500bp

The Credit Premium

Δ ASW (2Y IT-DE) = C + Δ Debt/GDP (IT-DE) + Δ [GDP growth IT – Avg Debt Servicing IT] + Δ Primary Surplus (IT-DE)


160 bp 12 Oct 14 150 bp =

Estimates of Credit component

2Y BTP-Schatz spread

10Y BTP-Bund spread

Pictet 121 bp 160 bpBank of Italy 120-150 bp ca. 200 bp

Regression shown refers to the 2 year case


The Expected Realignment in case of currency ‘divorce’


160 bp 12 Oct 14 150 bp = + 30%

Italy

30%

USA

Germany

Source: OECD, Bloomberg

France

EMU

Inception

Spain

Unit Labour Cost


Probability of Flotation


160 bp 12 Oct 14 150 bp = + 30%


Assumptions (see previous slides):

Expected depreciation of new ITL/DEM in case of currency exodus: 30% Credit premium: 120bp

Based on 2Y Yield to maturity (BTP, Schatz, swaps)

x 0%

24%

36%

2%

Medium term: barring ERF or Eurobonds,

Realignment Risk should be contained via converging fundamentals. Or new Crises?

Today: OMT (GCC a hurdle?)

Pictet Asset Management 13 November 2014 44

Ab-Normal Correlation regime (short run) Equity - Bonds

Growth, Inflation prospects improve

Equities Bonds

Sales, Earnings rise, Price rise

Yields rise, Price fall

Growth, Inflation prospects deteriorate

Sales, Earnings fall, Price fall

Yields fall, Price rise

EMU Crisis worsens

Negative Correlation

Equities-Bonds

Positive Correlation

Equities-Bonds

Sales, Earnings rise, Price fall

Peripheral Yields rise, Price fall

EMU Therapy


After 26 July, everything changes…

Speech by Mario Draghi, President of the European

Central Bank

at the Global Investment Conference in London 26 July 2012 Mario Draghi, President of the ECB, Vítor Constâncio, Vice-

President of the ECB,

Frankfurt am Main, 2 August 2012

[…] The Governing Council extensively discussed the policy options

to address the severe malfunctioning in the price formation process

in the bond markets of euro area countries. Exceptionally high risk

premia are observed in government bond prices in several countries

and financial fragmentation hinders the effective working of

monetary policy. Risk premia that are related to fears of the

reversibility of the euro are unacceptable, and they need to be

addressed in a fundamental manner. The euro is irreversible. […]

[…] Within our mandate, the ECB is ready to do whatever it takes

to preserve the euro. And believe me, it will be enough

[…] Then there’s another dimension to this that has to do with the

premia that are being charged on sovereign states borrowings.

These premia have to do, as I said, with default, with liquidity, but

they also have to do more and more with convertibility, with the

risk of convertibility. Now to the extent that these premia do not

have to do with factors inherent to my counterparty - they come

into our mandate. They come within our remit.


Outright Monetary Transactions (OMT): the «circuit breaker»

Positives

The ECB kept its promise to do “whatever it takes”: it falls within the ECB duties to repair distorted sovereign spreads as well as financial fragmentation among EMU countries

Proposed purchases : government bonds with 1-3years residual maturity. Good compromise

Unlimited amount may by bought by the ECB

The BCE explicitly gives up privileged creditor status on bonds purchased under OMT (NB: not under previous SMP!) – this increases the residual value of bonds for private investors

Trasparency as for: amounts purchased, its market value, etc.

the German government confirms: the BCE is operating within its mandate

Bundesbank only dissent

Negatives

“Stricter and effective” conditionality. Activation of OMT will depend on acceptance by Spain or Italy (if any) of IMF supervision. High domestic political cost

Bundesbank’s opposition still there (would weigh on activation)

Sterilisation of purchases under OMT in order to immunise monetary impacts (no QE)


Draghi shot the «black swan» of EMU break-up…


EMU Exit Strategy

ROADMAP (June ‘12)

Other Measures aimed at reducing Financial Fragmentation and Credit Crunch

LTRO (Dec’11-Feb’12); Repo rate cut (Jul ‘12). Likely again very soon (depo?)

OMT (Sep ‘12): BCE -> financial stability (conditional to PCCL/MoU with ESM)

TECHNICAL DECISIONS-ECB

Necessary and (temporarily) sufficient conditions

Necessary conditions

1. Banking Union: supervision & resolution, limited guarantee on bank deposits (2013)

2. Fiscal Union: SGP-F. Compact (Str.Def.<0,5%; Debt/GDP->60%, 5%/yr; Procedure)

3. Political Union: by 2020?

Sufficient conditions

Full Political Union: Risk pooling (Eurobonds, ERF) once Economic and Fiscal Convergence

is achieved (2015?). This process requires pooling Sovereignty

EMU Break-up: OMT fails, crisis, default, divergence?

END-GAME for EMU POLITICAL DECISIONS

Exp.

Rea

lignm

ent

Prob

abili

ty o

f Flu

ctua

tion

Cred

it Pr

emiu

m POLITICAL DECISIONS


EMU must progress on the RODMAP or... troubles ahead

Current Situation

One Country leaves (Greece or Germany?) National Currencies

EMU Disintegration (<10%)

Source: Pictet

EMU Integration (>90%)

Increasing number of new-national Currencies

No eurobond Weak Central Budget Authority

Eurobonds Strong Central budget Authority

Growing Fiscal Federalism

Fiscal Autonomy Monetary Union

BCE, ESM FMI etc.: Bridge Financing a

reinforced EMU structure

Gradual Process

Unless EMU integrates, tension re Austerity and/or ECB is likely (eventually leading to German Exit?)

Traumatic Event


Correlations between bonds and equities, Germany, Italy

CORRELATION between GERMAN BUNDS and MSCI EMU

The ‘core’ bonds (USA e Ger) negatively correlated with equities. This DOES NOT apply to Italy!

CORRELATION between ITALIAN BTP and MSCI EMU

-70%

-50%

-30%

-10%

10%

30%

50%

70%

gen-08 gen-09 gen-10 gen-11 gen-12 gen-13

Correlazione

Average


Average

Exceptional circumstances

Optimal Investment Theory

How to adapt

… in a distorted environment

Asset Allocation…


Expected volatilty

Implied Volatility (Index Options)

Uncertainty reduced by ‘endogenous’ Fed (unemployment doesn’t decrease, QE increses) and BCE’s OMT



MSCI World MSCI USA MSCI EMU MSCI EM Hedge HFRX MSCI Japan Commodities EM Debt HC Corporate Inflation L EM Debt LC €/$ Gov Bonds GOLD €/¥

Correlation among different Asset Classes

MSCI World MSCI USA MSCI EMU MSCI EM MSCI Japan Hedge HFRX EM Debt HC €/$ €/¥ Commodities GOLD EM Debt LC Corporate Gov Bonds Inflation L

MSCI World €

MSCI World €

Source: Bloomberg


-0,80

-0,70

-0,60

-0,50

-0,40

-0,30

-0,20

-0,10

0,00

0,10

0,20

0%

5%

10%

15%

20%

25%

30%

35%

40%

gen-08 gen-09 gen-10 gen-11 gen-12 gen-13 gen-14

Volatility and Correlation (weekly; 12M rolling)

Equity Volatility (St. Dev.)

Bond Volatility (St. Dev.)

Correlation (rhs)

Annualised Vol

Correlation Analysis If correlation falls (better if <0) when volatility rises, then the diversification benefit intensifies


Volatility and Correlation (weekly; 12M rolling)

Avg: -0,42


CORRELATION BETWEEN US TREASURIES and MSCI W ($)


CORRELATION BETWEEN ITALIAN BTP and MSCI EMU

-70%

-50%

-30%

-10%

10%

30%

50%

70%


Correlazione

Media

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%


Correlazione

QE2

QE1 Media


Correlations between bonds and equities, USA & Italy (Jan ‘13)

QE3


-60%

-40%

-20%

0%

20%

40%

60%

80%


Correlation

-80%

-60%

-40%

-20%

0%

20%


Correlation

CORRELATION BETWEEN US TREASURIES and MSCI W ($)


CORRELATION BETWEEN ITALIAN BTP and MSCI EMU

QE2

QE1 Avrg.


Correlations between bonds and equities, USA & Italy (now)

QE3

Avrg.


-0,8 -0,6 -0,4 -0,2 0 0,2 0,4 0,6 0,8 1

JPY

USD

Gold

Oil

€ Govies

Bund

Treasury

MSCI EM

S&P500

4/2011-4/2012 (d)

In the last 12 monthes, few defenses

CORRELATION BETWEEN MSCI EUROPE AND OTHER FINANCIAL ACTIVITIES

Source: Bloomberg

‘Sick’ Correlations: the collateral damage of the financial crisis


Different portfolios optimization methodologies (continued)

Source: Clarke, De Silva, Thorley (2012); Daly, Rossi and Herzog (2012)

We introduce now two different kind of portfolio optimizations, the Maximum Diversification and the Risk Parity approaches, which focuse on risk allocation, usually defined as volatility, rather than allocation of capital or returns (they are also known as risk-based approached). Maximum Diversification Portfolio The Maximum Diversification portfolio maximizes the ratio of weighted-average asset volatilities to portfolio volatility max

𝒘′𝝈

𝒘′𝛀𝒘

Risk Parity Portfolio In the Risk Parity Portfolio the weights must be chosen such that the contribution of each asset to the portfolio risk is equal. This requirement can be approximated by the constraint

𝑤𝑖

𝛿𝜎𝑃2

𝛿𝑤𝑖= 𝑤𝑗

𝛿𝜎𝑃2

𝛿𝑤𝑗 ∀ 𝑖, 𝑗 ∊ 1, . . , 𝑛


Equally weighted portfolio, balanced portfolio and risk parity portfolio performances

Source: Bloomberg MSCI World etc.

WHICH PORTFOLIO? In normal times: Markowitz

and optimal PTF (max

Sharpe Ratio)

With volatility but stable

negative correlation:

balanced PTF

With volatility and

uncertain correlations:

equally weighted PTF (max

diversification)

With volatility and changing

correlations: risk parity

based PTF (close to

minimum risk)

Repeated crises challenged Markowitz, Relative Value strategies (HF) due to sick correlations

After the 2008, the risk parity PTF if the best performing one!

Portfolio exercise: max diversification 2010


Conclusions • The benefits coming from diversification are directly proportional to the degree of decorrelation

among the investment portfolio’s assets.

• Since the subprime crisis of 2008, correlations remained relatively high (typical during

financial turmoils). On the contrary, the volatilities have experienced a normalization.

• One of the causes of the correlations behaviour is the standardization of the investors’

behaviour, affecting in particular intra-assets correlations. The correlation between equities and

bonds has been affected by the European Debt Crisis and by the behaviour of the Fed in the

USA, and later many other Central Banks adopting Quantitative Easing, that favour (at least a

temporary) inversion of the correlation sign from negative to positive.

• When there is uncertainty on the economic growth, the correlation between equities and bonds

should be ‘normal’ (negative): this could encourage holding a longer duration.

• Because of the paucity of decorrelations, there are now less opportunities than before. How to

face this new world? Two solutions: i) Reduce your Total Return objectives; ii) become more

«aggressive» in order to reach ‘sub-optimal’ but higher gains. Either way, we are induced to

diversify through additional presence of risky assets (equities).

In this last case, using a max Diversification portfolio (or based on Risk Parity), instead of a max Sharpe one, may hold better in the face of uncertain/unstable correlations.


Flexible approach to compensate for lower ex-ante Returns Risk and Return assumptions resulting from the Asset classes included in our Flexible Portfolio - Jan ‘13


TER


Equity Exposure

Ex Ante Volatility

Time

Growth Outlook

Extreme +

Extreme -

Secular Outlook

TAA

Managing risk: keep ex-ante volatility under control (8% Max)



Ex-Ante Volatility of Pictet Multi Asset Global Opportunities Risk Management in Portfolio Construction

Asset Class

Contribution to Volatility (bp)

Bonds 102 Cash 0

Equities 343 Unclassified -12

TOTAL 433

Volatility

Budget


MSCI World

MAGO (I)

Eur Bonds 3-5 years

Realized Volatility (240dd): MAGO: 3,3 MSCI World: 8,9 Eur Bonds 3-5 anni: 1,4

Performance of Pictet Multi Asset Global Opportunities Performance and Volatility of MAGO and its reference


Andrea Delitala – Investment Advisory

Milano, 8 Aprile 2014

Hope you received some hints…

… good luck for your financial DIY!


67

References

Berry R. Value-at-Risk: An Overview of Analytical VaR. Available at

http://www.jpmorgan.com/tss/General/email/1159360877242

Clarke R., De Silva H. and Thorley S. (2012). Risk Parity, Maximum Diversification, and

Minimum Variance: An Analytic Perspective. Journal of Portfolio Management, Forthcoming.

Daly D., Rossi S. and Herzog F. (2012). Methodology for the Construction and Enhancement of

Risk-Parity Portfolios. SwissQuant Group AG, Zurich, Switzerland: 416 – 419.

Duffie D. and Pan J. (1997). An Overview of Value at Risk. The Journal of Derivatives, Spring

1997, Vol. 4, No. 3: 7-49.

68 July 2012 Pictet Asset Management

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management: Pictet Asset Management SA, a Swiss corporation registered with the Swiss Financial Market Supervisory Authority FINMA, Pictet Asset Management Limited, a UK company authorised

and regulated by the Financial Services Authority, and Pictet Asset Management (Japan) Limited, a Japanese company regulated by the Financial Services Agency of Japan.

This document is for distribution to professional investors only. However it is not intended for distribution to any person or entity who is a citizen or resident of any locality, state, country or other

jurisdiction where such distribution, publication, or use would be contrary to law or regulation.

Information used in the preparation of this document is based upon sources believed to be reliable, but no representation or warranty is given as to the accuracy or completeness of those sources. Any

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This document has been issued in Switzerland by Pictet Asset Management SA and/or Pictet & Cie and in the rest of the world by Pictet Asset Management Limited and may not be reproduced or

distributed, either in part or in full, without their prior authorisation.

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Documents

Optimal Investment Theory Asset Allocation…didattica.unibocconi.it/mypage/dwload.php?nomefile=Delitalia_prese… · 720bp spread in the 2Y BTP-Schatz yields reached in November