How sovereign risk hits equities

The severe impact of the European debt crisis on financial markets has spurred EDHEC-Risk Institute to investigate whether equity investors can earn a premium through sovereign risk. Professor Nöel Amenc, EDHEC-Risk Institute director, speaks about the emergence of what could be a new risk factor and other research focusing on Asia.      

As the Eurozone debt crisis lurches from Greece to Italy and investor sentiment continues to deteriorate, EDHEC-Risk Institute, an academic research institute in finance, is investigating how sovereign risk can spread beyond bond markets and into the stocks and sectors of country-based equity markets.

“We are looking at what sovereign risk means for equities,” Amenc says. “What we want to see is if there is a clear sovereign risk – not credit risk – of countries.”

Ultimately EDHEC aims to discover if sovereign risk is a rewarded long-term risk factor that investors can exploit as a consistent source of return or on the contrary if sovereign risk, for want of a risk premium, should be entirely avoided in portfolio construction.

Amenc says the economic strength of a country has implications for companies doing business within its borders. For example, a weak sovereign will be unable to forcefully support systemically important businesses well beyond the traditional financial sector, whose fate, as we know from the last crisis, is intimately related to that of the States themselves – let alone construction, health or military systems – if they fall into crisis.

“Who will back me if I get into trouble?” Amenc asks. “A national bank or the IMF [International Monetary Fund]?”

The research will aim to identify and measure sovereign risk in stock market indexes, such as market capitalisation-weighted, minimum variance and fundamental indexes.

EDHEC will use the traditional asset pricing models to measure the importance of sovereign risk in the variation in returns over the long term. However this model requires “normality”, or an extended period in which the risk factor is present, for risk premiums to be detected. Sovereign risk will be difficult to gauge if the research concludes it is an “extreme”, rather than persistent, risk, Amenc says.

If it emerges as a reliable risk factor, sovereign risk would be a “problem” for stock pickers because it is not included in financial analysis frameworks, he says.

In separate work, EDHEC is researching how investors can gain a more comprehensive and informed picture of investment opportunities in Asia than what popular indexes provide.

“What is the true definition of Asia and what are the truly Asian stocks?” Amenc asks.

Pension and sovereign wealth funds worldwide are investing in Asian stock and bond markets. To a large extent, the set of investment opportunities they see are defined by the market indexes developed by investment banks, brokers and index companies, Amenc says.

“This is not transparent; it is proprietary work and the index classification criteria are not based on serious research,” he says. “We don’t have serious academic work evaluating the risk premium for Asia.

“What are the impacts of these very popular indexes on the risk-return trade-off for investors?” Amenc asks.

Current indexes do not cover the full range of investable companies in Asia or reveal whether listed companies provide direct exposure to economic activity in the region, Amenc says.

For example, no distinction is made between exporting and domestically focused businesses. This leads Amenc to say that “true” Asian stocks and risk factors are not defined.

“It is important to be able to analyse the relationship between the evolution of Asian economic indicators and the indices. More globally, the question of the economic representativeness of Asia indices is posed.”

Stocks exhibiting these factors are more likely to be domestically focused companies rather than exporters to developed economies, whose profitability is tied to consumer appetite in the West.

EDHEC will publish a series of volatility indexes for Asian stock markets, which aim to help investors hedge portfolios against market declines, in about six months’ time, Amenc says.

Some investors use the Chicago-based Volatility Index, which uses the implied volatilities of a broad range of S&P 500 index options to show the market’s expectation of 30-day volatility, to hedge Asian stock portfolios against market risk. Amenc

EDHEC is testing whether stock market volatility can be measured by systematically assessing the implied volatilities in option prices. However the low volume of options traded in Asian markets makes it difficult for investors to forecast volatility in the region, Amenc says.

But an assessment of the cross-sectional dispersion of stocks can serve as a proxy for their idiosyncratic volatility, Amenc says, which correlates with their systematic volatility.

“The idea is to use this indicator when the systematic volatility indicators are not available. It involves focusing above all on the change in volatility rather than the level of volatility itself.” ”
“When you want portfolio protection, you want to hedge yourself against changes in volatility.”

The project, led by Professor Stoyan Stoyanov, head of Asia-Pacific research , is supported by the Monetary Authority of Singapore as part of the research programme of EDHEC Risk Institute—Asia, which has been located in Singapore for two years.