MONETARY POLICY AND EXTREME VALUES LETS TALK ABOUT RISK

01

DATE: JUNE, 2013 SUMMARY REPORT AUTHOR: JEAN MEILHOC

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SUMMARY

I. JAPAN BOLD MONETARY POLICY: VIRTUOUS CYCLE OF REFLATION ............................................................. 3 I.I BOLD MONETARY POLICY SUPPORT FROM BANK OF JAPAN AS KURODA IS INSTALLED ................................................................... 3 I.II PRO-GROWTH ABE ADMINISTRATION TO PURSUE KOIZUMIS UNFINISHED BUSINESS..................................................................... 3 I.III POSITIVE CHANGES FOR EQUITY MARKET SUPPLY/DEMAND AND VALUATION ............................................................................. 3 II. LETS TALK ABOUT RISK ................................................... 5 II.I VARIANCE WITH ONE SOURCE OF RISK ..................................... 5 II.III VARIANCE WITH TWO SOURCE OF RISK .................................. 5 II.IV VALUE AT RISK ...................................................................... 6 II.V COMPUTATION ......................................................................... 9 CONCLUSION .............................................................................. 12

KEY WORDS: MACROECONOMICS; MONETARY POLICY; BANK OF JAPAN (BOJ); QUANTITATIVE EASING (QE); INFLATION; RISK MANAGEMENT; QUANTITATIVE ANALYSIS; VALUE AT RISK; VAR ONE; DELTA VAR

I. J APAN B OLD MONETARY POLICY: V IRTUOUS CYCLE OF

REFLATION

I.I Bold monetary policy support from Bank of Japan as Kuroda is installed Pre-requisite for equity investors nowadays as liquidity drives markets Inflation likely to move into positive territory by 2014

New era of weak yen following end of sage have status

I.II Pro-growth Abe administration to pursue Koizumis unfinished business Willing to open its market through new trade agreements Implies accelerating restructuring and improved efficiency at companies Aiming to unlock the cash from Japan Incs balance sheet to restart the economy

I.III Positive changes for equity market supply/demand and valuation Domestic investors both retail and institutional set to rethink their equity allocations Positive impact of mild inflation on valuations

Robust Monetary Policy Through QE and Asset purchases

Foreign direct investment exceeds current account surplus Trade balance keeps deteriorating Life insurers will likely reduce their currency hedge ratios

Inflation created through debt monetization and through foreign goods whose real value in Yen rise

Yen weakening

Changing expectations of economic agents: Hoarding cash is no longer a winning game and Wealth effect

Inflation

TRUST

and generate huge pressure to sell JPY

Higher Corporate earnings

Consumer activity increases as well as corporate re-leverage

Wages increase and goods and assets prices rise

II. L ET S TALK ABOUT RISK

Having discussed the various kinds of returns in considerable detail in a range of research papers, we now turn to measures of riskiness of Japanese investment. Just like return, there are various kinds of risk. Fluctuation prices could be measurable by statistical distributions. We will consider the total risk of an asset or a portfolio of assets as measured by its standard deviation, which is the square root of variance.

II.I Variance with one source of risk

Variance is a measure of the volatility of returns. It is computed as the average squared deviation from the mean Higher variance suggests less predictable profitability The standard deviation of returns of an asset is the square root of the variance
n i

of
2

returns.

Written

!2 ,

we

have:

"( R ! )
!=
o o o
i=1

n !1

. Y
, with:

Ri the return for period i, calculated as R =

Pt !1 Pt!1

P is the price of the asset n the total number of periods, assuming that it is the sample of the population of returns, and
n

!X
o o

i=1

We also annualized ! 2 by multiplying by the square root of a Y (252 days). It is usually the case in the investment world where we only have a sample of returns available instead of the population of returns. The above expression is useful to underestimates the variance.

II.III Variance with two source of risk

Like a portfolios return, we can calculate a portfolios variance When computing the variance of portfolio returns, standard statistical methodology can be used to find the variance of

the full expression of portfolio return. Although the return of a portfolio is simply a weighted average of the returns of each security this is not the case with the standard deviation of a portfolio unless all securities are perfectly correlated, with ! = 1 The standard deviation of a two-asset portfolio is given by the weighted square root of the portfolios variance:
2 2 ! p = w12! 12 + w2 ! 2 + 2 w1! 1w2! 2 "1,2 . Y

, where w1 and w2 is the amount of money invested in the first and the second asset respectively.

II.IV Value at Risk

In evaluating investments using expected return and variance, risk managers make two important assumptions. o First, they assume that the returns are normally distributed because a normal distribution can be fully characterized by its mean and variance first and second moment respectively o Second, they assume that markets are not only informationally efficient but that they are also operationally efficient. Returns, however, are not normally distributed; deviations from normality occur both because the returns are: o skewed, which means they are not symmetric around the mean and o the probability of extreme events is significantly greater than what a normal distribution would suggest referred to as kurtosis or fat tails in a return distribution. Highrisk profile among the mean could be observed. In financial mathematics and financial risk management, Value at Risk is a risk measure of the risk of loss on a specific portfolio of financial assets It is defined by risk exposure at a given probability level at a specified time horizon Mathematically, we have: VaR(q ) = Pt wt .! N .T . S (q ) where: o o o o o P is the price of the asset in time t w the amount invested in the asset
A !N the volatility calculated above regarding one or two A !1

source of risks T the square root of the time horizon divided by Y and the distribution assumption

S !1 (q ) . The latest

characterizes the inverse Student-t distribution On

Excel: =-TDIST(1-q; DF), with DF, the degree of freedom. This distribution take into account the fat tails explained in section II.I. or mathematically:

) , # k +1& t +1 (# + 1 "% 2& 2 . t $ 2 ' !+ %1 + ( . + k! " # k & $ k ' . % ( + . $2' * -

!1

Inverse cumulated normal [N(x)] & Student-t [F(x)] distribution

3 2 1 0 -1 -2 -3 0% 25% 50% -N-1(x) -F-1(X) 75% 100%

-F-1(X) -22.3 -7.0 -4.8 -2.9 -1.9 -1.1 -0.6 -0.3 0.0 0.3 0.6 1.1 1.9 2.9 7.0 22.3 1.6 2.3 3.1 1.3 0.8 0.5 70% 80% 90% 95% 99% 99.9% 0.3 60% 0.0 50% -0.3 40% -0.5 30% -0.8 20% -1.3 10% -1.6 5% -2.1 2% -2.3 1% -3.1 0.1%

-N-1(x) x

II.V Computation By importing data from Bloomberg PX_LAST NKY Index EURJPY Curncy From 6/14/10 to 6/13/13 we calculated Value at Risk shown below:

Value at Risk Global parameters: VaR NKY Index Confidence Interval (q)... 95.0% Time... 1 DF... 2 Time horizon (year)... 0.063 Student -F -1(1-q)... 2.9 Date... 13/06/13 Price ()... 12445 EURJPY... 126 Nb stocks... 1 Volatility... 22% Position... 12445 Price Std Dev ()... 174 Position Std Dev ()... 174 VaR(q) (in ).................................... 507 VaR (q) (in %)................................. 4.1%

Value at Risk Global parameters: VaR EURJPY Confidence Interval (q)... 95.0% Time... 1 DF... 2 Time horizon (year)... 0.063 Student -F -1(1-q)... 2.9 Date... 13/06/13 Price ()... 12445 EURJPY... 126 Nb stocks... 1 Volatility... 13% Position... 126 Price Std Dev ()... 1 Position Std Dev ()... 1 VaR(q) (in ).................................... 3 VaR (q) (in %)................................. 2.4%

Value at Risk Global parameters: Delta VaR Confidence Interval (q)... 95.0% Time... 1 DF... 2 Time horizon (year)... 0.063 Student -F -1(1-q)... 2.9 Date... 13/06/13 Price ()... 12445 EURJPY... 126 Nb stocks... 1 Volatility... 27% Position... 12445 Price Std Dev ()... 213 Position Std Dev ()... 213 VaR(q) (in ).................................... 622 VaR (q) (in %)................................. 5.0%

250

200

150

100

50

0 6/14/10

6/14/11

6/14/12

Delta VaR B(100) NKY Index EURJPY Poly. (Delta VaR B(100))

10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10%

Delta VaR

NKY Index

EURJPY

C ONCLUSION

As a conclusion: Inflation created through debt monetization and through foreign goods whose real value in Yen rise Changes expectations of investors Capital expenditure and acquisitions as well as consumer activities boost micro and macro economics Snowball effect Good opportunity to invest in Japan Risks need to be determine through Japanese investments as well as Yen currency Value at Risk threshold is computed thanks Student distribution to catch skewness and kurtosis uncertainty NKY Index crossed Delta VaR threshold: it means risk is higher than expected return opportunities. Investors have to buy a put or sell a call, or short the market. However, it becomes to go down. Investors have to be prepared to change their positions slightly to avoid liquidity risk Delta VaR can easily be adaptable in CPPI or OBPI strategies