VaR Shock Has Led to “Clean” EM Positions: Morgan Stanley

New research from Morgan Stanley has concluded that emerging markets investors faced a “VaR shock” in the first two weeks of March which led to the “unprecedented” weakness in EMFX markets as they cut overweight positions., but that shock has passed.

The research, by Min Dai, head of Asia Rates and FX strategy at Morgan Stanley, is the first time Morgan Stanley has provided analysis on how the EM VaR (Value at Risk) shock happened, what it led to, and what the bank thinks investors have done to reduce the risks.

The research came against a background where the JP Morgan Government Bond Index – Emerging Markets (GBI-EM) suffered the biggest monthly loss since the financial crisis. Dai acknowledges that EM volatility is “not new to EM-dedicated investors”, however, “The pace of FX weakness is unprecedented.”

Using positioning data, the research observes that most asset managers use historical simulations for their VaR calculations, which is a simple risk measure that uses volatility to indicate to portfolio managers how much loss their portfolio could suffer the next day with a certain degree of confidence (usually 95 or 99%). With volatility at historically low levels, most managers were observing low VaR risk – this of course changed dramatically as the Covid-19 crisis accelerated.

The resulting spike in volatility, therefore, has increased real money VaR “significantly”, Morgan Stanley says, and has “likely forced portfolio managers to unwind their positions”.

The research estimates 95% VaR for a GBI-EM portfolio on 28 February would have been 9bp, i.e., there was a less than 5% chance that the portfolio would lose 9bp of alpha on 2 March. Assuming a risk limit of 50% above (13.5bp), a GBI-EM portfolio VaR would have touched its limit on 13 March and would have further shot up to 21bp on 17 March, 55% above the risk limit. To reduce VaR, investors would likely have chosen to hedge in more liquid or more volatile EMFX (for example, BRL, MXN, RUB, IDR or ZAR), which would explain the recent move, Dai suggests.

The good news from the research, Dai says, is that the shock has past. “GBI-EM funds have lost almost 100bp alpha in the last six weeks, leading to negative YTD alpha,” he writes. “The good news is that our analysis (based on two measures) shows positioning is quite clean in EM now.”

Colin Lambert

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