WHATIFGREECELEAVESTHEEURO?

JUNE2015

WhatIfGreeceLeavestheEuro?
StressTestingtheGreekExitScenarioUsingMSCIRiskManager

CarloAcerbi,ZsoltSimon,VivekSridhar,ThomasVerbraken

June2015

Introduction
AsthefinancialpresswondersaboutapotentialGreekexitfromtheeuro,thispaperexaminesapossibleoutcome
forfinancialmarketsbyemployingaGreekExit(Grexit)stresstestusingMSCIRiskManager.1
Thisstresstestscenario,aswellasitsoutcomeonselectedexampleportfoliosintheIllustrationsection,
demonstratesthepotentialimpactofaGreekexitonthemarketsoutsideGreecebyusingthesocalled
RiskManagerspredictivestresstesttool.2Thescenariodesignisbasedonthefollowingguidelines:

Aminimalsetofcorefactorswaschosentospreadtheshockacrossmarkets,illustratingcauseandeffect,
notonlycorrelation.

Apropagationofcorefactorshockswasbasedonaregressionperformedinasimilarturbulentperiod,
i.e.,theEuropeanSovereignDebtcrisis,fromDecember2011toMay2012.

Therelativemagnitudeofcorefactorshockswasstudiedviaaprincipalcomponentanalysisofthechosen
period,withafewadditionalshocksadjustedtoaccountforchangesinfactorexposuretoGreecesince
May2012.

ThispaperoutlinesourrecommendedGreekExittestscenarioaswellasthereasonsbehindthetestingdesign.

TheGreekExitScenario
TheimplicationsforGreeceofaeurodeparture(referredtoasGrexit)illustratedbythehypotheticalstresstest
wouldbedramatic.Inthisillustrativescenario,Greecewouldadoptanewcurrency,whichimmediately
experiencesaseveredevaluation.Herearethemajorpotentialramificationsofsuchascenariointhisexample:

AllGreekpublicandprivatedebtorswouldbeunderstressastheystruggletorepayeurodenominated
debtwhiletheirincomestreamsaredenominatedintheNewGreekcurrency,potentiallyleadingto
defaultforvirtuallyalloutstandingbonds.

Greekequitieswouldnotbesparedeither.Foraforeigninvestor,thecompoundeffectofthecurrency
devaluationandadropinequitypricescouldleadtomassivelossesonGreekequity.

Thisisanillustrativescenario,notMSCIspredictionofhowaGreekexitwouldplayout.

RiskManagerhasseveraltoolsforstresstesting.Thepredictivestresstesttoolismeanttodescribethepropagationoftheshocksofalimited
numberofchosenriskfactorsacrosstherestofthemarkets.

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

TheeffectontheEuropeanandglobaleconomywouldprobablybelimited,astheGreekeconomyissmall
relativetothetotaleurozone.Globalfinancialmarkets,however,wouldexperienceincreasedturbulence.
StocksoffinancialinstitutionswithexposuretoGreekdebtlikelywouldsuffer,aswouldequitymarketsin
generalasaflighttoqualityensued.

InEuropeanbondmarkets,yieldsofperipheralcountries(Italy,Spain,Portugal)wouldincreasedueto
fearsofcontagion.TheyieldsofGermanBundsandothercorecountrieslikelywoulddrop,againdueto
flighttoqualityeffects.Finally,theeurowoulddepreciateasfundswillflowoutofEurope.

DesigningaGreekExit(Grexit)StressTest
TwoDesignChoices
TheproposedMSCIRiskManagerstresstestconsistsoftwomajorparts:GreeceandWorldexGreece.
TheeffectonGreeceismodeledwithacompositestresstest3thatconsistsof:

AJumptoDefaultstresstestforallGreekbonds,bothsovereignandcorporate

Ageneral80%shockonallGreekstocks

FortheWorldexGreecescenario,weuseapredictivestresstest.Tospecifyapredictivestresstest,weneedto
definethesetofcorefactorsandshockmagnitudes,togetherwiththeestimationwindowandthereturnhorizon
usedfortheregression.IntheEuropeexGreecepredictivestresstest,wechosetoshockthefollowingcore
factors:

Italian5Ygovernmentyield:+200bps

Portugal5Ygovernmentyield:+200bps

German5Ygovernmentyield4:46bps

EurostoxxBanksindex:25%

WeusedtheestimationwindowfromDecember1,2011toMay31,2012,andworkedwithweeklyreturns.
Inthenextsectionwemotivatethesechoices.

SeetheRiskMetricsStressTestingGuideformoreinformationonthecompositestresstest.

Thisshockwouldproducenegativerates,asofJune30,2015.Dependingonhowtheinstrumentismodeled(negativeratesallowedornot),thismay
leadtointerestratessetwithaminimumlevel.

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

RationaleBehindtheDesignChoices
EstimationWindowandReturnHorizon
WhenmodelingaGreekexitstresstest,weenvisionedashockofamagnitudethattypicallycorrespondstolarger
returnhorizonswithleadlageffectsoftheorderofdays.Therefore,itwasnotadvisabletousedailyreturnsfor
theregressionbutlongerreturnhorizonsinstead.Whenthereturnhorizonistoolarge,ontheotherhand,there
aretoofewindependentobservationsintheestimationwindow.Hence,weeklyreturnsareanaturalcompromise.
Fortheestimationperiod,wewentbacktoearly2012inthedepthsoftheEuropeanSovereigncrisis(sparkedby
Greecesfinancialproblems).TheGreek5YGovernmentyieldpeakedduringthisperiod,ascanbeseeninExhibit
1.TheyieldreacheditshighestvalueattheendofMay2012,whichistheendofourestimationwindow.TheCDS
marketofGreeksovereigndebtfroze(CDSquotesstopped)inMarch2012whenGreecerestructuredits
governmentdebtheldbyprivatecreditors.Duetothecomovementbetweenthegovernmentyieldandthe
sovereignCDSspreadandduetothelimitedliquidityoftheCDSduringthecrisisperiod,wedecidedtouse
peripheralyieldsinsteadofperipheralCDSspreadsinthedefinitionofthestresstest.
Forthestartoftheestimationwindow,welookedattheevolutionofcorrelationsthroughoutthecrisisperiod,as
showninExhibit2.Wewantedrelativelystablecorrelationsthroughouttheestimationwindow.Therewasashift
inmanycorrelationsaroundDecember2011,whichiswhywechosethatpointasthestartoftheestimation
window.

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

35

30000

30

25000

Yield(%)

25

20000

20

15000

15

10000

10
5

5000

CDSSpread(bps)

Exhibit1:Greece5YGovernmentYieldandtheCDSSpreadoftheGreekGovernment

GreeceGovernmentPostExchangeBenchmarkZero
CMAGreece(Senior,CR03)CDS
MarkitHellenicRep(SNRFOR,CR)CDS

Source:Reuters,CMA,Markit.

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

Exhibit2:RollingCorrelationofItalian5YGovernmentYieldwithotherEuropeanYields
GermanGovernmentDebt
BenchmarkZeroCoupon

SpanishGovernmentDebt
BenchmarkZeroCoupon

0.5

FrenchGovernmentBenchmarkZero

GreeceGovernmentPostExchange
BenchmarkZero
HungarianGovernmentDebt
BenchmarkZeroCoupon

0.5

IrishGovernmentDebtBenchmark
ZeroCoupon

ItalianGovernmentBenchmarkZero
PolishGovernmentDebtBenchmark
ZeroCoupon
PortugueseGovernmentDebt
BenchmarkZeroCoupon

Source:Correlationswerecalculatedbasedon5YgovernmentyielddatafromReuters.

CoreFactorSelection
ThedefaultofGreekgovernmentandcorporatedebtwouldcauseperipheralyieldstospikeduetofearof
contagion.TheconsequentflighttoqualitymaypotentiallyleadtotighteningGermanyieldsandaweakening
euro.,ThestockpriceofbanksthatareexposedtoGreekdebtwouldalsobeunderpressure.Theaimofourtest
wastomodelthoseeffectswithalimitednumberofcorefactors,whicharethenpropagatedtootherriskfactors
withthepredictivestresstest.WerepresentedtheyieldsofperipheralEUcountriesbytheItalian5YGovernment
yield,whichisingeneralcorrelatedwithotherperipheralcountriesyields(seeExhibit3).Thecorrelationwith
Spain,theotherlargeperipheralEUeconomy,wasespeciallyhigh.Tocapturethechangeofthecorecountries
yields,weincludedtheGerman5Yyield.Finally,weshockedtheEurostoxxBanksIndextomodelthenegative
returnofthefinancialstocks.

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

Exhibit3:CorrelationBetweenEuropeanYields
German
Spanish
French
Greece
Hungarian Irish
Italian
Polish
Portuguese
Govt5Y
Govt5Y
Govt5Y Govt5Y
Govt5Y
Govt5Y Govt5Y
Govt5Y
Govt5Y
GermanGovt5Y
1.00
0.03
1.00
SpanishGovt5Y
FrenchGovt5Y
0.24
0.47
1.00
GreeceGovt5Y
0.24
0.35
0.12
1.00
HungarianGovt5Y
0.25
0.24
0.31
0.20
1.00
IrishGovt5Y
0.11
0.44
0.19
0.40
0.18
1.00
ItalianGovt5Y
0.21
0.69
0.41
0.21
0.26
0.40
1.00
PolishGovt5Y
0.13
0.45
0.30
0.24
0.45
0.32
0.54
1.00
PortugueseGovt5Y
0.18
0.22
0.01
0.07
0.13
0.09
0.12
0.00
1.00

Source:Correlationswerecalculatedbasedon5YgovernmentyielddatafromReutersbetween[date]and[date].

MagnitudeofShocks:NoEuropeanCatastrophe
Accordingtoouranalysis,theseverityofcontagionthroughtheeurozoneperipheralcountrieswasless
pronouncedthanin2012whentheprevioussovereigndebtcrisisoccurred.Thereason:Portugal,Italy,Spainand
Irelandmadeimportantstepsinthelastthreeyearstobuildmorestableeconomiesandtominimizetheimpactof
afuturecrisis.Exhibit4showsthehistoryofthebetaofEuropeangovernmentyieldscomparedtotheGreek
governmentyield.Notethatin2015theGreekbetashavebeenmuchlowerthantheywereinpreviousyears.
ThedirectionoftheshocktotheGermanyieldandtotheEuropeanbankingstocksisderivedfromaprincipal
componentanalysis(PCA)performedonthecorrelationmatrixofweeklyriskfactorreturnsovertheestimation
period,asthefirstprincipalcomponentgavethemostplausibledirectionofashock.Thecorrelationbetweena
selectedsetofriskfactorsisshowninExhibit5,whereastheoutcomeoftheprincipalcomponentanalysisis
showninExhibit6.Thecorrelationduringtheestimationwindowwasasweenvisionedinourstresstest,i.e.,if
theItalianyieldincreases,thentheeurowoulddepreciate,equitywoulddrop(especiallythebankingsector),the
Germangovernmentyieldwoulddecreaseandperipheralgovernmentyieldswouldincrease.5Thefirstprincipal
componentshowedthesamedirectionofshocksonthecorefactors.Hence,wemodeledtheGrexitscenarioby
usingtheabovementionedestimationwindowfromDecember1,2011toMay31,2012andappliedashockin
thedirectionofthefirstprincipalcomponent.
WesettheItalian5Ygovernmentyieldshockat+200bps,andshockedtheGerman5Ygovernmentyieldaccording
tothedirectionofthefirstprincipalcomponent.AstheItalianyieldincreasedby200bpsoverthelastthree
monthsoftheestimationperiod,wethinkthatthisshocksizeisreasonable.FortheEurostoxxBanksindex,wedid
nottakethemagnitudeassuggestedbythePCA,butwescaledtheshockdown,basedonthecurrentlylower
correlationwiththeItalian5Yyield.Thereason:backin2012,banksweremuchmoreexposedtoGreek
governmentdebt,whiletodaygovernmentshavetakenovermuchofthisdebt.

Thiswastheresultofthespecificchoicewemadefortheriskfactorsandtestperiod.Differentchoicesmayyieldmateriallydifferentresults.

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

Exhibit4:Rollingbetaof5YEuropeanGovernmentYieldstothe5YGreekGovernmentYield

1
0.5
Apr15

Sep14

Feb14

Aug13

Jan13

Jul12

Dec11

0.5

Jun11

1
GermanGovt5Y

SpanishGovt5Y

FrenchGovt5Y

GreekGovt5Y

HungarianGovt5Y

IrishGovt5Y

Source:betaswerecalculatedbasedon5YgovernmentyielddatafromReuters.

Exhibit5:CorrelationBetweenSelectRiskFactors

RiskFactor
Euro
EUROSTOXX50Index
EUROSTOXXBanksIndex
DEMGovt60M
ESPGovt60M
GRDGovt60M
ITLGovt60M
PTEGovt60M

Vol
1.26
2.59
5.59
0.10
0.34
1.85
0.35
1.79

Correlation
1.00 0.50
0.50 1.00
0.57 0.86
0.38 0.63
0.36 0.32
0.17 0.26
0.38 0.55
0.04 0.07

0.57
0.86
1.00
0.60
0.42
0.18
0.67
0.06

0.38
0.63
0.60
1.00
0.03
0.24
0.21
0.18

0.36
0.32
0.42
0.03
1.00
0.35
0.69
0.22

0.17
0.26
0.18
0.24
0.35
1.00
0.21
0.07

0.38
0.55
0.67
0.21
0.69
0.21
1.00
0.12

0.04
0.07
0.06
0.18
0.22
0.07
0.12
1.00

Exhibit6:PrincipalComponentAnalysis.
RiskFactor
Euro
EUROSTOXX50Index
EUROSTOXXBanksIndex
DEMGovt60M
ESPGovt60M
GRDGovt60M
ITLGovt60M
PTEGovt60M

PC1
0.36
0.46
0.48
0.33
0.32
0.21
0.41
0.00

PC2
0.07
0.20
0.13
0.47
0.53
0.18
0.30
0.56

PC3
0.13
0.03
0.19
0.25
0.06
0.90
0.26
0.05

PC4
0.03
0.16
0.10
0.33
0.34
0.18
0.17
0.82

PC5
0.90
0.21
0.16
0.09
0.02
0.02
0.33
0.07

PC6
0.02
0.55
0.23
0.69
0.29
0.17
0.23
0.01

PC7
0.18
0.23
0.07
0.11
0.64
0.19
0.67
0.02

PC8
0.07
0.56
0.79
0.08
0.05
0.10
0.18
0.02

PCvol 1.89 1.22 0.96 0.88 0.78 0.53 0.47 0.33

PercExpl 45
19
11
10
8
4
3
1

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

AsecondimportantobservationisthatthePortuguese5Yyieldwasnotshockedinthefirstprincipalcomponent,
mostlikelyduetoidiosyncraticeventsaffectingPortugalduringtheestimationwindow.Inordertoproperly
capturethepotentialcontagioneffectonPortugal,weaddPortugal5Ygovernmentyieldtooasacorefactorand
shockitby200bps.
Insummary,weproposedthefollowingshocksinourtest:

Italian5Ygovernmentyield:+200bps

Portugal5Ygovernmentyield:+200bps

German5Ygovernmentyield:46bps

EurostoxxBanksindex:25%

Inthenextsectionweapplythestresstesttotwosampleportfolios.

Illustration
Toillustratethisproposedstresstest,weappliedourGreekexitscenariotoasampleportfolioreplicatingtheMSCI
ACWIIndex100%andtoasampleportfolioconsistingofgovernmentbondswithamaturityof10years.
ThepredictedreturnaswellasthestandarderrorarebrokendownbycountryandareshowninExhibit7.
Fortheequityindexbasedportfolio,weseeanegativereturnforallcountries,wherebytheseverityofthedrop
dependsontheproximitytoGreece,e.g.,Spain(aperipheralcountry)andAustria(whoselargestcompaniesare
banks)experiencerelativelylargedrops.AlsonotethattheGreekequitydrops80%inpriceand,sinceitisnotpart
ofthepredictivestresstest,thereisnostandarderrorforGreece.Whilethegovernmentbondsinperipheral
countrieswouldexperienceadropinvalueinthisillustration,corecountries,suchasGermanyandthe
Netherlands,wouldgainvalue,aswellasothercountriesoutsidetheeurozone(e.g.,theU.S.,GreatBritain),which
generallybenefitfromflighttoqualityeffects.Greeceitselfwouldexperiencedefaultacrosstheboard.Notethe
implicationsforPortuguese,ItalianandCypriotdebt:

ThepricedeclineinthePortuguesebondismuchlessthanthepricedeclineintheItalianbond,even
thoughboth5Ygovernmentyieldshavebeenshockedwith200bps.Thisismainlycausedbythedifferent
betaoftherespective10Ygovernmentyieldstothe5Yyield.ForItaly,thebetaofthe10Yyieldtothe5Y
yieldis0.70,whereasforPortugalthisisonly0.33.Asaresult,thePortuguese10yearbondsuffersless.

ThereisanextremepredictedreturnwithlargestandarderrorforCypriotdebt.ThereasonisthatCyprus
wassufferingitsownfinancialcrisisin2012andweshouldnotextrapolatefromthatperiod.Instead,for
portfolioscontainingCypriotassets,wemaywanttoaddanadditionalcorefactorforCyprusorstress
thoseassetsinadifferentway.

Thesetwoexamplesillustratethatoneshouldexercisecarewithstresstests,especiallywhenusingpredictive
stresstesting.Itmaybenecessarytocustomizethestresstestforindividualusecases.

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WHATIFGREECELEAVESTHEEURO?
JUNE2015

Exhibit7:StressTestResultsforMSCIACWIandaSampleGovernmentBondPortfolio.

MSCIAWCI(selectcountries)
Country
deltaPV deltaPVSE
AT
20.9%
1.4%
AU
2.3%
1.1%
BE
9.9%
1.0%
CZ
9.2%
1.2%
DE
10.2%
1.1%
DK
7.7%
1.2%
ES
14.0%
0.9%
FI
11.2%
1.6%
FR
10.7%
1.0%
GB
6.6%
1.0%
GR
80.0%
HU
18.4%
2.4%
IE
7.9%
1.1%
IT
18.6%
0.8%
JP
0.5%
0.9%
LU
7.6%
0.9%
MT
3.5%
1.8%
NL
6.8%
0.9%
NO
7.8%
1.3%
NZ
2.1%
1.0%
PH
6.1%
1.6%
PL
11.0%
1.3%
PT
11.4%
1.7%
SE
11.9%
1.5%
US
2.6%
1.0%
TotalACWI 4.1%
0.9%

Bondportfolio
Country deltaPV deltaPVSE
AT
0.5%
0.7%
BE
2.5%
0.8%
CY
22.0%
17.9%
DE
4.9%
0.2%
ES
7.4%
1.0%
FI
3.8%
0.3%
FR
0.3%
0.6%
GB
5.3%
0.5%
GR
20.4%
IE
2.3%
0.8%
IT
11.5%
0.5%
JP
7.2%
0.9%
LT
3.6%
0.7%
LU
2.9%
0.2%
LV
1.3%
0.7%
MT
0.1%
0.2%
NL
4.8%
0.4%
PT
5.7%
1.4%
SI
4.5%
1.0%
SK
0.3%
0.7%
US
7.7%
0.7%

Conclusion
AstheGreekdebtcrisisdrivesapotentialexitfromtheeuro,weproposeaRiskManagerstresstesttomodelthe
impactofaGreekexitscenarioonfinancialassets.GiventhedifferentscenarioimplicationsonGreeceversusthe
WorldexGreece,wedesignedtwodifferentstresstests.OurtestsassumesthatinGreece,equitywouldsuffer
heavily,andvirtuallyallbondsdefault.TheimpactonEuropeandtheworldwouldbecausedbyfearofcontagion
andasubsequentflighttoquality.Theseeffectsledtowideningperipheralyields,tighteningcorecountryyields,a
weakeningeuroandadownwardpressureonequity,inparticularfinancialstocks.However,thetestresults
indicatedthattheimpactwouldnotbedevastatingfortheeurozone.

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WHATIFGREECELEAVESTHEEURO?
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