Building a clean risk free rate curve in the post 2007 world

OK, what's going to follow will sound like plain banality to credit risk folks or market risk people somehow involved in credit risk. It is also a digression in a blog focused on the FX related world. But sounded interesting to me, so decided to share.

It's basically a simple fact I was told about recently by a credit risk expert (yeah, don't want to sound like I came up with a smart idea when someone brought the fact to me, so should at least mention it upfront...) and which struck me for multiple reasons: (1) theoretically easy to understand (2) has a lot of practical applications for anybody crunching market data for any use (3) it is an original angle from which to witness the changes pre and post credit crisis.

So here is the deal: a few years ago, it was quite standard to build a risk free rate curve using vanilla swap rates for durations above 2 years(ish). We were talking about liquid instruments, traded in massive volumes, representing an industry standard and free of credit risk... That is a few years ago.

Indeed, going back to a simple feature of vanilla IR swaps, these carry coupons which, depending on the underlying currency, get paid quarterly, bi-annually or sometimes annually. Now let's look at what happens even in the highest standard coupon frequency, ie the quarterly one. Well, technically, on a given swap leg paying 3-months coupons, the long position holder is lending cash to his / her counterparty for a quarter like on any loan. So in a way, he / she is short credit risk. The point is that nobody used to care about that subtle point and was more than happy to use swap rates considering them as risk free.

But things changed since 2007, and 3 months now sometimes seem like an sweating eternity... So credit risk guys decided to shift gear and started considering that the only duration worth being considered short enough to carry the risk free name was the overnight one. And consequently, they started replacing vanilla swap rates with OIS swap rates when building risk free rate curves.

Another way to get a grasp on that difference would be to monitor the spread between Libor rates and OIS rates. These used to be as small as 10 pips, but in the tensed hours of the credit crisis in September 2008, they surged to multiples of hundreds of pips...

 

Source: Bloomberg.com

More than 50% odds for the Euro to disappear before year end... Really??!!

At least that's what Jacques Attali told a French newspaper on Nov. 25^th 2011.

On paper, the guy has been the French macro-economics Wonderkid for a few decades: X-Mines, Sciences Po and ENA graduate (for the vast majority of the world population who don't care about the French education system, it's a bit like having a resume combining MIT and Cal Tech, plus Harvard Kennedy School of Government and a Stanford Political Science major, first in class all the way long...), he also scored an economics Phd, then went on becoming advisor to the French President Mitterrand before heading the European Bank for Reconstruction and Development, and more recently created the micro-finance group PlaNet Finance (well, that last project is cool, so check it out when you get a chance: http://www.planetfinancegroup.org/EN/). Don't mean to add up, but he is also a famous writer and symphonic orchestra conductor...

The issue is that the guy is not “street smart”. More precisely, he tends to live in a theoretical bubble that he will call the “real world”. For those who a want a proof and speak French, please read his book “La crise, et après?” (“The crisis, and then what?”), where he gives his views on the 2008 / 2009 credit crisis and what we should do next to rebuild the world economy and financial system. There, he pulls out a lot of excellent macro-economy conceptual tools, but shows a clear lack of concrete investment banking industry experience and hands-on knowledge about financial derivatives.

And the exact same thing happened a few days ago. After going through a set of sovereign debt crisis management measures which look good on paper (a real program of bonds buy-backs by the ECB, drastic European agreements on public deficit management, in depth reform of the ECB to give it access to tax income plus the ability to issue Euro-bonds), he reveals the output of some theoretical model known to him only: there are more than 50% odds for the Euro to disappear before year end...

Mmm... How to say that... I agree that the Euro zone is in trouble, that European leaders are slow to find a way out and show us the end of the tunnel, and I am even OK to consider that there is a risk for the Euro system to break down. But 50% plus odds on a break down before the end of 2011??!! Jacques, to be honest, I don't even want to have an analytical debate with you about it, you're too smart for me. But I'm more than happy to book you the bet on that one...

US National Debt – Democrats vs. Republicans negotiations: Round 2

So here we go again. In July, they exposed their usually hidden political games, and the whole world understood that for US congressmen, trying to knock down their opponent in the next presidential race is more important than solving a real national issue like the public deficit. On the way, they ended up loosing their AAA sovereign rating. But in November, they put on the gloves again, and can't agree on a decent policy around the public budget management.

Could be funny if the clock was not ticking. But it actually is, and pretty fast... If you don't believe me, just check for yourself:

http://www.usdebtclock.org/

I fixed my eyes on that thing for less than a minute and the balance moved up by more than USD 2.5 millions... This must be something in the tune of 40 or 50 times the average US household annual income!

And overall, the US national debt points out at more than USD 15 trillions, making it an average of USD 134,000 per household, and around 100% of the GDP.

Now, I'm laughing, but to my American friends, please take no offense: I'm French. So if I'm laughing, it's sort of a nervous laugh, because we are next in line for the downgrade. With a debt to GDP ratio of 85-90% and a funding spread vs. German Bunds in the range of 200 pips, only the French President and Minister of Finance still believe that we deserve our AAA rating...

Volatility Forecasting & Neural Networks – Learning The Google Check Reflex

Just got another example of the fact that when you get an idea, you should seriously consider that someone may already have explored it. Basically something along the lines “Before shouting Eureka and dreaming of your Nobel Prize speech, just Google the concept and find out how many books were already written on the topic...”.

Other than bringing you back to earth regarding your IQ, it can actually save you a lot of time. Other people's research may already have proven that the idea works and explained how, or you may discover without sweating too much time on it that it's actually crap...

Concretely, trying to analyze how I could leverage neural networks algorithms to better forecast volatility, I ended up running a quick Google search only to discover at least 5 solid books on Amazon dealing only with that specific target: applying the well known artificial intelligence development tool to quantitative finance and market data forecasting...

Now it may be time to tell a few high level words on neural networks for those interested. Basically, computer science folks specialized in machine learning / artificial intelligence developed in the 80's an algorithm built around a network of multivariate functions which behave both individually and all together as a piece of human brain tissue: each component has the ability to input multiple “impulses” from other components, and has the capacity to send in response a single “impulse” to one of several other components. The link between the inputs and the output of each component is based on parameters which can be “trained” on a data sample to “learn” how to best predict the final output of the overall network (a bit like you set up a linear regression on a sample to then predict the outcome of events outside of your sample).

The above is a massive shortcut, but it summarizes the main idea. For those who want to dig deeper, I would heavily recommend the online free “Machine Learning” course designed by Professor Andrew Ng, Director of the Stanford University Artificial Intelligence Lab, and his team:

http://www.ml-class.org/course/auth/welcome

There is an advanced track which requires completing assignments, but you can also sign up simply to watch the video lectures and download the related notes. And lectures 8 and 9 happen to be on neural networks.

Anyway, following this class and looking at the applications of neural networks mentioned there, I could not see any around finance, and for a second I thought I may have put the finger on something... But as mentioned above it was simply the fact that The Google Check Reflex should prevail.

Cheers,

Olivier

Any target level for the Yen intervention?

Since the JPY 3 trillions intervention package on October 31^st, which led the USDJPY up to 79.50 within a few minutes, the question around the target level Azumi san must have defined seems to be a fair one.

Indeed, since then, the spot first took a bearish biais down to the 78.00 region in spit of a second Asia morning move to 78.40 on November 1^st, and from that point it started to oscillate within 20-25 pips daily ranges around that level. And up to today, it started to look like the Japanese government was relatively satisfied with that short term outcome of the intervention, taking into account the bullish pressure of the Euro sovereign crisis on safe heaven currencies.

But the range broke today, with a spot swinging from 78.10 levels down to 77.58 and now stuck below 77.80. And if one can accept the idea that the political drama taking place in Italy had an impact, the next interrogation is to find out if the Japanese government will make another push to bring the spot back in the range and close to 78.00.

One clue may be that the only time we hit 77.80 since the October 31^st intervention, there was a shift across 78.00 the next morning during Asia hours, before a stabilization in the range discussed above.

But to find out, I guess we'll have to sleep another night and wake up early to ride the trend in case ;-)

Referendum or not?

OK nice one Mr Papandreou... This time you managed to upset everybody!


First you told the whole world 2 days ago that you would call a referendum to get your nation's permission before accepting the bailout plan "offered" by the European leaders...

Obviously Nicolas Sarkozy did not expect and did not like this one. FYI, a few days before, the French President went on national TV to tell us that thanks to his efforts combined with those of the German Chancellor, they had just saved Europe. The guy is down to less than 30% positive opinions in the poll 7 months ahead of the Presidential election, so he kind of needed a trophy to bring back from Brussels, and he thought he had it until you blew up his plan...

On the German side, the Bild tabloid said it all by asking Angela Merkel for a referendum to consult the German people on their willingness to keep Greece in the Euro zone.

As for the Chinese, who were asked to dig in their deep cash pockets, well... They started to wonder why they should invest on people who "work 3 times less" than they are "to earn 10 times more:... No comment.

And if you ask, I'm sure that in Japan, Azumi san did not like it either. Under his command, the BoJ intervenes massively and daily on the forex markets to put a stop on the Yen strength and help out Japanese exporters, and you come out with the kind of announcement which triggers a rally to safe heaven currencies.


But we had not seen it all. Indeed, you last trick: telling us this morning that the referendum would take place on December 4th, to explain us this afternoon that it would most likely not happen... Sweet!

Though to be honest with you, the news came out 1 hour ago, and looking at the charts, looks like the markets don't listen to you anymore. Surprised?


And to conclude, I was wondering where you would go on vacation next as you may not be welcome anymore in lots of countries, but then I realized you still have Santorini... Arghh!

Should France still be Triple A?

During the recent negotiations in Brussels around the European sovereign credit crisis, the French President Nicolas Sarkozy was heard whispering to one of his advisors: “If we loose our Triple A, I'm dead...”. Politically speaking that is to say.

When I read that story, I actually wondered how come it's not already done by now. And here, I am obviously talking about the Triple AAA rating that France has managed to keep so far, even though I am not exactly one of Sarkozy's fans.

Indeed, it intuitively sounded to me like the data that could be gathered around France, both on a stand alone basis and on a comparative basis, would not be shiny. But I had to confess that I had never checked for myself in details. So to be as fair as possible, I decided to give it a go. And here is the outcome.

Zooming on France itself, the main macro-economic benchmarks and public budget data which can be extracted from the IMF and OECD public databases speak for themselves. Indeed it appears that between 2007 and 2010:

→ The average annual GDP growth was as low as 0.77%;

→ The public debt increased from 2.70% of the GDP to 7.00% of the GDP;

→ The public deficit increased as well, from 64.22% of the GDP to 82.33% of the GDP;

→ The average unemployment rate hit 8.87%.

Looks pretty bad for a Triple A nation...

Now, one could argue that during that period, the whole world underwent a massive financial crisis which heavily impacted all major economies. And that is indeed true. Hence the necessity to conduct a comparative analysis to check how well or bad France has actually managed the crisis versus other big players, including also being Triple A.

To do so, I got hold of the annual GDP growths, the public debt levels and unemployment rates of all 17 Euro zone countries for years 2007 to 2012 (IMF data, using their economic analysis department forecasts for 2011 and 2012). Then, I ranked these countries by averaging their “performances” on these indicators (using equal weights for all 3), and added their current S&P sovereign ratings next to the output. Finally, for benchmarking reasons, I computed the same elements on the G7 countries which are not part of the Euro zone, and on the BRIC countries (minus the ranking).

The indicators selection and the computing method are of course not perfect, but sufficiently representative for a high level analysis, and they give a good sense of who stands where. They use very significant indexes which truly reflect the health of an economy and the quality of public budget management, and project those in 2012, just like rating agencies do when assessing sovereign ratings. And as a matter of fact, the figure below confirms that France is not doing so well:

 

In brief, France end ups ranked number 12, with averages of 0.64% for the GDP growth, 78.32% of the GDP for the public debt and 9.03% for the unemployment rate. All other AAA countries of the Euro zone have better ranking, and even countries like Cyprus with a BBB rating come on top of France. And looking down at the BRIC countries which all have poorer ratings than France,well...

To close the loop, I ran a similar analysis on all Euro zone, G7 and BRIC countries which hold a Triple AAA rating today. There 8 of them. And ranking them, France comes last:

In conclusion, I don't hold a crystal ball, but it may get tough for France to hold on to its platinum rating. And if a downgrade does happen, one of the two Euro zone leaders will be hit. May get a bit shaky then, and not only for the French President...

Cheers,

Olivier