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RISK IN EMERGING CAPITAL RISK IN EMERGING CAPITAL MARKETSMARKETS
…from a Global Tactical Asset Allocation Perspective.
Emerging Capital Markets: DefinitionEmerging Capital Markets: DefinitionShare of World Population, 1996
Emerging84%
Developed16%
Share of World Equity market Capitalization
Emerging9%
Developed91%
The IFC Definition: Income less than $9,000…
Emerging19%
Developed81%
21% of World GDP
85% of the World Population
11% of the World Equity Market Capitalization
Emerging Markets: PerformanceEmerging Markets: Performance Returns Returns
Return per Year (1995-2005)
15%
6%
4%
9%7%
-4%
-5%
0%
5%
10%
15%
20%
ASIA EastEurope
LatinAmerica
MiddleEast and
Africa
AllEmergingMarkets
USA
Emerging MarketsEmerging MarketsVolatilityVolatility
Standard Deviation of Returns per Year (1995-2005)
16%
25%
40%
30%
20%23%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
ASIA EastEurope
LatinAmerica
MiddleEast and
Africa
AllEmergingMarkets
USA
Emerging MarketsEmerging Markets Bullish and Bearish MonthsBullish and Bearish MonthsNumber of Months with Positive and Negative Returns
(1995-2005)
68
78 7681 78 81
64
54 5651 54 51
0
10
20
30
40
50
60
70
80
90
ASIA EastEurope
LatinAmerica
MiddleEast and
Africa
AllEmergingMarkets
USA
Emerging MarketsEmerging Markets Bullish and Bearish Local ReturnsBullish and Bearish Local Returns
Annual Returns during Bullish and Bearish Markets (1995-2005)
66%
100%
58% 67% 61%31%
-69%
-108%
-61%
-95%
-67%
-36%
-150%
-100%
-50%
0%
50%
100%
150%
ASIA EastEurope
LatinAmerica
MiddleEast and
Africa
AllEmergingMarkets
USA
-100%
Emerging MarketsEmerging Markets Bullish and Bearish US ReturnsBullish and Bearish US Returns
-60
-40
-20
0
20
40
60
US+ geometric mean US- geometric mean
Average Returns During U.S. Up and Down Markets
-60
-40
-20
0
20
40
60
US+ geometric mean US- geometric mean
Average Returns During U.S. Up and Down Markets
AnnualReturnU.S. $
-0.10
0.10.20.30.40.50.60.70.80.9
Since 1980 Since 1990
Emerging MarketsEmerging Markets Correlations with World ReturnsCorrelations with World Returns
-0.10
0.10.20.30.40.50.60.70.80.9
Value
– Liquidity– Repatriation
Limits
– Systematic– Currency– Information– Sovereign/
Credit Risk
– Currency Translation
– Accounting Adjustments
– Taxes
Cash Flow Timing Return Risk
International Stock and Country SelectionInternational Stock and Country SelectionA critical component of stock valuation in international context is knowing the appropriate “required rate of return”.
Traditional Risk DecompositionTraditional Risk Decomposition
Total Risk
Variability 2i
Market Risk
2 2m
•Beta Risk
Specific Risk
2ei
Unique Risk Firm Specific Risk
Extramarket Risk Common Factor Risk
Macro Risk Oil Price, G7 inflation,FX to $, Spreads, G7 industrial production
“Micro” Risk•Local Beta•Size (Market Cap)•Value Vs Growth
Country RiskPolitical, economic,
financial risk
Return: Rit – rft = i + i[Rmt – rft] + eit
Risk: 2i = 0 + 2 2
m + 2ei
Returns and Beta from 1990 through 1998:03
R2 = 0.1064
-0.2
-0.1
0
0.1
0.2
0.3
0.4
-0.5 0 0.5 1 1.5 2
Beta
Ave
rage
ret
urns
Incorporating the Asian crisis makes the model look even worse.
Emerging Markets RisksEmerging Markets RisksWorldWorld Beta? Beta?
Emerging Markets RisksEmerging Markets Risks Local Beta?Local Beta?
Countries (HML-Beta) (HML-Beta-down) (HML-Beta-up)
All countries -0.0023*** -0.0156*** 0.0209***
Colombia -0.0354** -0.0558*** 0.014
Egypt 0.0137 -0.042*** 0.0619***
Israel 0.0003 -0.0197*** 0.031***
Korea -0.0062*** -0.0175*** 0.014***
Malaysia -0.0132*** -0.0355*** 0.0258***
Morocco -0.0107*** -0.0116*** 0.0099**
Peru -0.0197*** -0.0302*** 0.0187**
Philippines -0.0093*** -0.0157*** 0.0177***
Poland -0.0005 -0.0156*** 0.0167***
Taiwan -0.0067*** -0.0187*** 0.0116***
Thailand -0.001 -0.0099*** 0.0252***
Emerging Markets RisksEmerging Markets Risks Size, Value, Investability, liquidity RisksSize, Value, Investability, liquidity Risks
Size (x $1,000) Price-to-book Investability Turnover
Inv. N-inv. Inv. N-inv. Inv. N-inv. Inv. N-inv.
Argentina 817.03 140.80 1.42 1.07 0.78 0.00 0.46 2.36
Brazil 1,490.95 505.89 1.15 1.01 0.72 0.00 0.52 0.10
China 2,086.73 489.70 2.00 12.94 0.79 0.00 1.27 1.39
Egypt 2,135.99 396.30 18.45 9.02 0.64 0.00 0.29 0.29
India 28,053.19 5,839.61 37.51 21.29 0.29 0.00 1.48 0.51
Korea 856.36 176.31 1.79 1.27 0.69 0.00 2.50 1.78
Malaysia 687.16 245.33 3.54 5.43 0.68 0.00 0.43 0.51
Russia 4,018.64 1,649.39 3.66 0.70 0.54 0.00 0.34 0.14
Thailand 569.21 240.25 67.07 29.41 0.36 0.00 0.71 1.92
Turkey 677.87 278.59 12.64 4.61 0.57 0.00 1.62 3.70
All Markets 1,921.26 450.52 7.69 4.85 0.66 0.00 0.64 0.79
Rethinking Risk in Emerging MarketsRethinking Risk in Emerging Markets Return DistributionReturn Distribution
High Serial Correlations in Short-run (Basis for Momentum strategies)
Long-term Mean Reversion (Basis for Value strategies)
Positive Skewness and Kurtosis (Fat Tails, high probability for large surprises)
Returns with positive skewness are characterized by many small losses with a few extremely large gains—i.e., Investors prefer small losses with extremely large gains.
Positive excess kurtosis shows a greater chance for an investor to receive a very large positive or negative return —i.e., investors would gladly trade a 100% loss on one investment for a potential 300% gain
Returns, variance and kurtosis…Returns, variance and kurtosis…
0
5
10
15
Variance
- 2
- 1
0
1
2
Skewness
5
7.5
10
12.5
Expected Return
0
5
10
15
Variance
Source: Harvey and Siddique (2000)
or Kurtosis
Developed versus Emerging markets: SkewnessDeveloped versus Emerging markets: Skewness
-2
-1.5
-1
-0.5
0
0.5
1
Average Skewness in Developed Markets
Data from MSCI
-2
-1.5
-1
-0.5
0
0.5
1
Average Skewness in Emerging Markets
-1
0
1
2
3
4
5
6
Average Excess Kurtosis in Developed Markets
Developed versus Emerging markets: KurtosisDeveloped versus Emerging markets: Kurtosis
Data from MSCI
-1
0
1
2
3
4
5
6
Average Excess Kurtosis in Emerging Markets
• Openness to foreign entry can be limited• Securities are thinly traded and illiquid• Insider trading laws, accounting standards and reporting, and contracts enforcement differentials.• Frequent government interventions in the economy and financial markets—i.e., expropriation, nationalizations and capital freeze.• Financial institutions can have political influences; concentrated banking and financial activities in few major institutions “moral hazard” is frequent.Thus, Both conditioning information (or risk) and higher moments matter and are related…to the marginal information associated with:
• Trading Risk• Investable Risk• Political, economic and financial Risks
Sources of excess Variance, Skewness and Kurtosis in Emerging Markets…
Emerging Markets Risks Emerging Markets Risks Trading RiskTrading Risk
High transaction costs: over 5% for a round trip.
Many trades may fail to settle.
Illiquidity: cannot sell your position without taking substantial price cut.
Short-sales may not be allowed in EMs
Cost of a Round Trip -- Purchase andLater Sale of an Individual Stock
Bid/Offer Country Commission Stamp Taxes Spread Total
Argentina 1.00% 0.48% 1.25% 2.73%
Brazil 1.00 0.14 2.48 3.62
Indonesia 1.30 0.30 1.50 3.10
Korea 0.80 0.50 2.25 3.55
Malaysia 1.20 0.10 1.09 2.39
Thailand 1.30 - 1.89 3.19
Germany 0.50 - 0.49 0.99
Japan 0.40 0.30 0.75 1.45
United States 0.13 - 0.27 0.40
Source: Morgan Stanley International Portfolio Desk and Authors'Estimates.
Emerging Markets Risks Emerging Markets Risks Trading Risk (Information content of intraday Trading Risk (Information content of intraday
trading…)trading…) Girard and Biswas (2006)
Volatility persistence
Developed 0.866 Emerging 0.794
Volatility persistence
Expected Volume
Unexpected Volume
Developed 0.665 0.026 0.273 Emerging 0.634 -0.173 0.498
Emerging Markets Risks Emerging Markets Risks Trading Risk: It has evolved– Cairo and Trading Risk: It has evolved– Cairo and
Alexandria Stock ExchangeAlexandria Stock Exchange
Period: 01/01/98 to 05/31/01
Volatilitypersistence
Expected Volume
UnexpectedVolume
Average 0.6255
Average 0.5183 -0.3916 0.7290
Period: 06/01/01 to 05/23/05
Volatility persistence
Expected Volume
Unexpected Volume
Average 0.7839
Average 0.5128 0.1808 1.4099
Girard and Omran (2006)
Emerging Markets Risks Emerging Markets Risks Trading Risk: Istanbul Stock ExchangeTrading Risk: Istanbul Stock Exchange
1987-1993Volatility
persistenceExpected Volume
UnexpectedVolume
Average 0.7679Average 0.7949 -0.1067 0.3691
2000-2005Volatility
persistenceExpected Volume
UnexpectedVolume
Average 0.8905Average 0.8879 0.0264 0.0846
Girard and Kilmaz (2006)
Emerging Markets Risks Emerging Markets Risks Investable Risk: Foreign Ownership controlInvestable Risk: Foreign Ownership control
Foreign ownership limits are often imposed in EM
Market integration has a fundamental influence on asset prices:
Permitting cross-border ownership of equity increases market value by 3.3% (Henry, 2000), and 10.4% for firms eligible to be purchased by foreigners, (Chari and Henry 2002).
Because risk premia are reduced, large capital inflows, relaxed financing constraints, reduced FX volatility.
Investability
Inv. N-inv.
Argentina 0.78 0.00
Brazil 0.72 0.00
China 0.79 0.00
Egypt 0.64 0.00
India 0.29 0.00
Korea 0.69 0.00
Malaysia 0.68 0.00
Russia 0.54 0.00
Thailand 0.36 0.00
Turkey 0.57 0.00
All Markets 0.66 0.00
The Effect of LiberalizationThe Effect of Liberalization
Prices
High Expected Announcement Implementation Low ExpectedReturns of Liberalization Returns
PI
PS
Time
Segmented Integrated
Asset Prices and Market Integration
Return to Integration
-0.10
0.00
0.10
0.20
0.30
0.40
0.50
0.60Pre Post
Average Annual Geometric Returns
Evidence: Stock Markets Returns After Evidence: Stock Markets Returns After LiberalizationLiberalization
Standard Deviation of GDP Growth Rates1980-2000
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
ARGBRA
CHLGRC
IND
KORM
EXZAF
THAZW
ECOL
JOR
MYS
NGAPAK
PHLVEN
IDN
PRTTUR
NZLESP
JPN
LKA
Average
Stan
dard
dev
iati
on
Pre-liberalization Post-liberalization
Stock Markets Volatility After LiberalizationStock Markets Volatility After Liberalization
-0.10-0.050.000.050.100.150.200.250.300.350.400.45 Pre Post
Correlation with World
Stock Markets Correlation After LiberalizationStock Markets Correlation After Liberalization
Emerging Markets Risks Emerging Markets Risks Investable Risk and Investable PremiumInvestable Risk and Investable Premium
CountriesStocksInv.
StocksN-inv.
Return (Inv.)
Vol.Return (N-Inv.)
Vol.Inv.
premium
Argentina 41 17 0.0033 0.12 -0.0075 0.12 0.0108
Brazil 112 31 0.0080 0.10 0.0067 0.11 0.0013
China 73 235 0.0007 0.11 -0.0013 0.08 0.0024
Egypt 42 67 0.0050 0.08 -0.0097 0.05 0.0147
Korea 145 31 -0.0063 0.11 -0.0141 0.11 0.0078
Malaysia 127 46 0.0003 0.10 -0.0001 0.11 0.0004
Mexico 122 40 0.0181 0.10 0.0100 0.09 0.0081
Peru 36 35 0.0012 0.08 0.0002 0.08 0.0014
Philippines 65 51 -0.0043 0.08 -0.0052 0.08 0.0009
Russia 38 24 0.0227 0.17 0.0024 0.12 0.0203
Turkey 75 27 0.0016 0.15 -0.0006 0.14 0.0022
All countries 1,768 1,235 0.0051 0.12 0.0001 0.10 0.5%
Girard (2006)
Emerging Markets Risks Emerging Markets Risks Determinants of investable risk…Determinants of investable risk…
Conflictsrating
Corruptionrating
Investment profile
rating
SocialTensionsrating
Law andOrderrating
DebtServicerating
InvestablePremium -0.019*** -0.005*** -0.005*** -0.004*** -0.002 0.001
MarketPremium
Value Premium
Size Premium
Mom.Premium
InvestablePremium
Intercept -0.0028*** -0.0051*** -0.0083*** 0.0109*** -0.0007
World Premium
0.0882 -0.0366 -0.0734 0.0152 0.1411***
WorldValue Premium
0.0161 0.0276 0.1158 0.0356 -0.0869**
Local Factors
Global Factors
Girard (2006)
Emerging Markets Risks Emerging Markets Risks Investable Risk: it is priced!Investable Risk: it is priced!
PeriodIndependent variables
Standardizedcoefficients
t-statistic Adj.R2
Market factor 0.519 9.85*** 0.287
1988-2004 Value factor 0.029 4.28***
1768 Stocks Size factor 0.083 5.61***
Momentum factor -0.009 -1.66*
Investability factor 0.351 7.59***
Girard (2006)
– Political Risk: risk of loss when investing in a given country caused by changes in a country's political structure or policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of profits.
– Economic Risk
– Financial Risk
Emerging Markets Risks Emerging Markets Risks Country RiskCountry Risk
Risk Category Score Range
Very High Risk 0.0-49.5
High Risk 50.0-59.5
Moderate Risk 60.0-69.5
Low Risk 70.0-84.5
Very Low Risk 85.0-100.0
Emerging Markets Risks Emerging Markets Risks Country Risk Ratings predict inflation
00.1
0.20.30.40.5
0.60.70.8
0.91
0 20 40 60 80 100
Composite Rating
Infla
tion
expe
ctat
ions
for
1997
Emerging Markets Risks Emerging Markets Risks Country Risk Ratings are correlated with wealth
$0
$5,000
$10,000
$15,000
$20,000
$25,000
0 20 40 60 80 100
Composite ratings for 74 countries
Per
cap
ita
real
GD
P
Emerging Markets Risks Emerging Markets Risks Country Risk Ratings predict volatility
R2 = 0.5033
0%
10%
20%
30%
40%
50%
60%
70%
0 20 40 60 80 100
Composite Country Credit Rating
An
nu
ali
zed
Vo
lati
lity
Emerging Markets Risks Emerging Markets Risks Country Risk Ratings predict correlation
R2 = 0.6809
-20%
0%
20%
40%
60%
80%
100%
0 20 40 60 80 100
Institutional Investor Countyr Credit Rating
Co
rrel
ati
on
wit
h M
SC
I A
C W
orl
d
R2 = 0.2976
-10%
0%
10%
20%
30%
40%
50%
0 10 20 30 40 50 60 70 80 90 100
Composite Rating
Ave
rage
retu
rns
Emerging Markets Risks Emerging Markets Risks Country Risk Ratings explain returns
Country risk, stock selection, country Country risk, stock selection, country allocation: 4 examples…allocation: 4 examples…
Turkey: Too culturally different or financially, economically and politically too immature?
Russia: Potentials…by watch Putin
Brazil: surprisingly robust market
Venezuela: How to do bad when everything goes well?
The Case of Turkey: Cultural The Case of Turkey: Cultural Differences or Financially, Politically Differences or Financially, Politically and Economically too unstable?and Economically too unstable?
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
2000 2001 2002 2003
RET_CZECHRET_ESTONIARET_EUROPERET_HUNGARYRET_LATVIA
RET_LITHUANIARET_POLANDRET_SLOVAKIARET_SLOVENIARET_TURKEY
Fundamentals (Beta, size, P/B)?Fundamentals (Beta, size, P/B)?
0
1
2
3
4
5
6
7
8
9
2000 2001 2002 2003
PB_CZECHPB_ESTONIAPB_EUROPEPB_HUNGARYPB_LATVIA
PB_LITHUANIAPB_POLANDPB_SLOVAKIAPB_SLOVENIAPB_TURKEY
0.0
0.2
0.4
0.6
0.8
1.0
1.2
2000 2001 2002 2003
MKTBETA_CZECHMKTBETA_ESTONIAMKTBETA_EUROPEMKTBETA_HUNGARYMKTBETA_LATVIA
MKTBETA_LITHUANIAMKTBETA_POLANDMKTBETA_SLOVAKIAMKTBETA_SLOVENIAMKTBETA_TURKEY
0
400
800
1200
1600
2000
2400
2800
2000 2001 2002 2003
SIZE_CZECHSIZE_ESTONIASIZE_EUROPESIZE_HUNGARYSIZE_LATVIA
SIZE_LITHUANIASIZE_POLANDSIZE_SLOVAKIASIZE_SLOVENIASIZE_TURKEY
Or country specific (Economic, Or country specific (Economic, Financial, Political)?Financial, Political)?
-4
-3
-2
-1
0
1
2
2000 2001 2002 2003
ECONRZ_CZECHECONRZ_ESTONIAECONRZ_EUROPEECONRZ_HUNGARYECONRZ_LATVIA
ECONRZ_LITHUANIAECONRZ_POLANDECONRZ_SLOVAKIAECONRZ_SLOVENIAECONRZ_TURKEY
-3
-2
-1
0
1
2
2000 2001 2002 2003
FINRZ_CZECHFINRZ_ESTONIAFINRZ_EUROPEFINRZ_HUNGARYFINRZ_LATVIA
FINRZ_LITHUANIAFINRZ_POLANDFINRZ_SLOVAKIAFINRZ_SLOVENIAFINRZ_TURKEY
-3
-2
-1
0
1
2
2000 2001 2002 2003
POLRZ_CZECHPOLRZ_ESTONIAPOLRZ_EUROPEPOLRZ_HUNGARYPOLRZ_LATVIA
POLRZ_LITHUANIAPOLRZ_POLANDPOLRZ_SLOVAKIAPOLRZ_SLOVENIAPOLRZ_TURKEY
Indeed…Indeed…
RETURN2 Coefficient t-Statistic Prob.
Intercept 0.02818 0.29 0.7737
Beta -0.09001 -0.48 0.6327
PTBV -0.92828 -1.06 0.2947
SIZE 0.02150 1.59 0.1185
ECONRISK -0.04038 -2.04 0.0474 b
FINRISK -0.09044 -4.17 0.0001 a
POLRISK -0.06276 -1.90 0.065 c
Adjusted R-squared 0.331113
Russia
Mikhail Khodorkovsky, Oligarch. Mikhail Khodorkovsky, Oligarch. Shareholder and former CEO of Shareholder and former CEO of Yukos oil company. Sentenced to 8 Yukos oil company. Sentenced to 8 years in prisonyears in prison
0
200
400
600
800
1000
1200
1400
0
10
20
30
40
50
60
70
80
Political Risk
Stock Index
Russia: Russia: Impact of politics on investment policyImpact of politics on investment policy
Equity market Russia looks attractive large inflow of oil revenues improves financial position
and stimulates domestic economy valuation is very cheap, price/earnings = 8 But politics is a major factor—i.e., state is interfering
increasingly and reversing privatizations, also risk for politically motivated attacks on companies of oligarchs
Consequences for investment policy:– Small overweight position in Russia
– select stocks with good political relations or low political profile
BrazilBrazil
Luiz Inácio Lula da SilvaLuiz Inácio Lula da SilvaPresident of BrazilPresident of Brazil
Has Has improvedimproved economy economyagainst expectations. Not against expectations. Not directly implicated in recent directly implicated in recent corruption scandalcorruption scandal
0
10
20
30
40
50
60
70
80
0
100
200
300
400
500
600
Political risk
Stock Index
Financial Risk
Economic Risk
Brazil: Brazil: Impact of politics on investment policyImpact of politics on investment policy
Corruption scandal has shocked Brazil—i.e., Members of parliament paid for support, illegal campaign financing
Though, sound monetary (not fiscal) policy remains unchanged and elections in 2006 are unlikely to change this successful policy
improved economic fundamentals, cheap valuation Consequences for portfolio positions:
– Overweight position in Brazil
– select stocks that benefit from declining interest rates and high commodity prices
Venezuela:Venezuela: Watch for Watch for a Nut Casea Nut Case
0
100
200
300
400
500
600
700
800
900
1000
0
10
20
30
40
50
60
70
80
Chavez is elected
ConclusionConclusionEvolution of Integration and International ValueEvolution of Integration and International Value
Dramatic internationalization of world: Economic integration through increased trade leading to
current account surpluses, floating exchange rates, single digit inflation, and lower debt levels
and Financial integration has also increased through
liberalization of capital markets leading to a broader selection of company targets, access to growth and innovation in new markets, reduced taxes in selected markets, reduced borrowing costs, and reduced risk (diversification among less correlated markets)
But political, financial and economic policies will remain important!
GTAA Vs STAA
Strategic Tactical
Unconditional Conditional
Slow evolvingweights
Dynamicweights
Constantweights
Asset Allocation StrategiesAsset Allocation Strategies
Implication on Portfolio management: Implication on Portfolio management: Conditioning Information and Portfolio Conditioning Information and Portfolio AnalysisAnalysis
Er
Vol
Add conditioninginformation and weightschange through time. Frontier shifts.
Traditional fixed weightoptimization (contrarian)in 2-dimensional setting
• Conditioning information makes a difference Adding conditioning information is like adding extra assets to an optimization
ChinaChina
• 9,5% real growth 35% export growth 50% of GDP invested each year
0
50
100
150
200
250
25
30
35
40
45
50
55
60
65
70
75
Political risk
Financial Risk
Economic Risk
Stock Index
ChinaChina Tax advantages for foreign direct investments to produce export
products More roads, more rails, more (air)ports, real estate (since 2002 the
people of China may mortgage their homes) Securing oil resources home and abroad, increasing electricity
generating capacity Banks: Huge capital injections, banning local government involvement
and implementation of risk management People: Favor investments in rural areas, where still 60% of the people
live, improving legal certainty (rights of ownership) and pensions to increase disposable income
Investment plays based on reform: Production: Car producers Infrastructure: Transportation, shipping companies, property
developers Energy: Oil companies, power producers Banks: Listed state banks People: Supermarkets, food producers or processors
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