SEBON's Red Flag on 51 Companies: Estimating 30-Day Downside Risk Using Monte-Carlo Simulation VAR

Article by Santosh Adhikari 

The Securities Board of Nepal (SEBON) recently issued a fresh warning about the possible risk of investing in 51 companies listed on the Nepal Stock Exchange (NEPSE). SEBON's press release comes on the back of stock markets touching record highs as the country’s economy continues to face disruption due to the second wave of the Covid-19 pandemic.

Anyone who has followed the stock market over the past year will know that the bourses have been performing impressively, ignoring economic disruptions during the second wave. The strong market performance is a stark contrast to the real economic growth of Nepal, which has suffered due to localized lockdowns imposed during the first and second waves. Even considering the above expectations earning growth of the companies, the stock prices cannot be explained by fundamentals alone.

Let's get a close-up look at the 51 companies that are deemed risky by SEBON. The stocks of 51 companies, with the exception of a few, are rising abnormally. For example, just in one year, stocks of 10 companies surged by 100 - 200%, 13 companies by 200-300%, 8 companies by 300-400%, 3 companies 400-500%, 5 companies 500-600%, and 4 companies by over 600%. If you ask me, is it normal? Well, the simple answer is ‘NO’. To protect the integrity of the investors, I will not comment further at this stage as not to prejudice any individual company. The least I can say is that I don’t find any valid reason for such a rise.

Because the SEBON warning was meant for the public, share price started falling value in a negative way, yet their effect could be even more devastating in the future. Many investors are under a lot of pressure, and things got heated. It’s easier to prevent a big mess than to clean one up, therefore the main aim of this article is to estimate the downside risk of stocks that is deemed risky by SEBON. The point here is that estimating the downside risk of your stock holdings will help you gauge the amount of money you will likely lose over the next 30-days.

The technique used is the Monte-Carlo estimation of VAR. Monte Carlo Simulation is a type of computational algorithm that is used to estimate the possible outcomes of an uncertain event. For this article, the historical price of 51 companies was retrieved from Nepal Stock Exchange (NEPSE) from 02/08/2020 to 16/06/2021. Some companies were listed in NEPSE a little later, for example, CGH was listed in NEPSE on 5th February 2021, data of such companies are available only after that period. The dataset is analyzed using Python specialized libraries (Pandas, Numpy, and Matplotlib).

Putting the reader in perspective, I tried to write in very plain language with fewer lines of code. Please note that one has to run the MC simulation separately for 51 companies in question. As you can see in the actual code, 500 random trials are drawn, but it’s up to you how many simulations you can set up. The MC- simulation of each company is shown below. For example, the graph has three components: time period (represented by X-axis, in our case- it is 30-day), a confidence level (denoted by the red line, which is 95%), and a loss amount (represented by Y-axis). The exact amount of potential fall in share price over the next 30-day time period starting from 17/06/2021 with different confidence levels is provided in the table.

Now let’s take one more look at it. For example, according to historical records, the average daily return of Corporate Development Bank Limited (CORBL) is 0.009027 or 0.9027% over the period from 02/08/2020 to 17/06/2021. During the same period, the daily volatility of CORBL was 0.034825 or 3.49%. The share price of CORBL on 17/6/2021 was Rs 683. Now, we can say that there is a 95% probability that over the period of the next 30-day starting from 18/06/2021, the share price of CORBL will not fall below Rs 584. Put another way, there is a 5% chance that the share price of CORBL will fall below Rs 584. Now, one can check the expected fall in the share price of CORBL at different confidence levels attached to it, which is shown in the table below. It is beyond the scope of this article to analyze one by one, as the data in the table speak itself.

The information in the above table answer the question, What is my worst-case scenario in the next 30 days? If one has invested in any of the companies above, this will give you an idea of what the share price might like in the next 30 days. Many people don’t like surprises. Losing money can be a catastrophe. Therefore, risk management is very important to identify the potential losses and develop strategies to minimize such losses.

Like last year, 2021 is not a normal year as Nepal is facing a second wave. Despite this, the stock market is touching a record high. SEBON responded firmly to this phenomenon.  I won’t argue whether SEBON did right or wrong, but the least I can say is better late than never, however it hit my mind where on earth SEBON has been all this time and let the madness happen. As a regulatory body why there is no early intervention/investigation from the fact that stocks are rising abnormally. I am certain that Pandora’s box of stock market problems will be opened up soon.