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RISK IN EMERGING CAPITAL MARKETS

RISK IN EMERGING CAPITAL MARKETS. …from a Global Tactical Asset Allocation Perspective. Emerging. 19%. Developed. 81%. Emerging Capital Markets: Definition. The IFC Definition: Income less than $9,000…. 21% of World GDP 85% of the World Population

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RISK IN EMERGING CAPITAL MARKETS

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  1. RISK IN EMERGING CAPITAL MARKETS …from a Global Tactical Asset Allocation Perspective.

  2. Emerging 19% Developed 81% Emerging Capital Markets: Definition The IFC Definition: Income less than $9,000… 21% of World GDP 85%of the World Population 11% of the World Equity Market Capitalization

  3. Return per Year (1995-2005) 20% 15% 15% 9% 10% 7% 6% 4% 5% -4% 0% -5% ASIA East Latin Middle All USA Europe America East and Emerging Africa Markets Emerging Markets: Performance Returns

  4. Emerging MarketsVolatility

  5. Emerging MarketsBullish and Bearish Months

  6. Emerging MarketsBullish and Bearish Local Returns -100%

  7. Emerging MarketsBullish and Bearish US Returns

  8. Emerging MarketsCorrelations with World Returns

  9. International Stock and Country Selection A critical component of stock valuation in international context is knowing the appropriate “required rate of return”. Value Cash Flow Timing Return Risk • Currency Translation • Accounting Adjustments • Taxes • Liquidity • Repatriation Limits • Systematic • Currency • Information • Sovereign/Credit Risk

  10. Traditional Risk Decomposition Return: Rit – rft = ai + bi[Rmt – rft] + eit Risk: s2i = 0 + b2 s2m+ s2ei Total Risk Variabilitys2i • Market Risk • b2s2m • Beta Risk Specific Risk s2ei Extramarket Risk Common Factor Risk Unique Risk Firm Specific Risk Country Risk Political, economic, financial risk Macro Risk Oil Price, G7 inflation, FX to $, Spreads, G7 industrial production • “Micro” Risk • Local Beta • Size (Market Cap) • Value Vs Growth

  11. Emerging Markets RisksWorld Beta? Incorporating the Asian crisis makes the model look even worse.

  12. Emerging Markets RisksLocal Beta?

  13. Emerging Markets RisksSize, Value, Investability, liquidity Risks

  14. Rethinking Risk in Emerging MarketsReturn 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

  15. Returns, variance and kurtosis… or Kurtosis Source: Harvey and Siddique (2000)

  16. Developed versus Emerging markets: Skewness Data from MSCI

  17. Developed versus Emerging markets: Kurtosis Data from MSCI

  18. Sources of excess Variance, Skewness and 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

  19. Emerging Markets Risks Trading 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

  20. Emerging Markets Risks Trading Risk (Information content of intraday trading…) • Girard and Biswas (2006)

  21. Emerging Markets Risks Trading Risk: It has evolved– Cairo and Alexandria Stock Exchange • Girard and Omran (2006)

  22. Emerging Markets Risks Trading Risk: Istanbul Stock Exchange • Girard and Kilmaz (2006)

  23. Emerging Markets Risks Investable 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.

  24. The Effect of Liberalization Asset Prices and Market Integration Prices Segmented Integrated PI PS Return to Integration Time High Expected Announcement Implementation Low Expected Returns of Liberalization Returns

  25. Evidence: Stock Markets Returns After Liberalization Average Annual Geometric Returns

  26. Stock Markets Volatility After Liberalization

  27. Stock Markets Correlation After Liberalization Correlation with World

  28. Emerging Markets Risks Investable Risk and Investable Premium Girard (2006)

  29. Emerging Markets Risks Determinants of investable risk… Local Factors Girard (2006) Global Factors

  30. Emerging Markets Risks Investable Risk: it is priced! Girard (2006)

  31. Emerging Markets Risks Country Risk • 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

  32. Emerging Markets Risks Country Risk Ratings predict inflation

  33. Emerging Markets Risks Country Risk Ratings are correlated with wealth

  34. Emerging Markets Risks Country Risk Ratings predict volatility

  35. Emerging Markets Risks Country Risk Ratings predict correlation

  36. Emerging Markets Risks Country Risk Ratings explain returns

  37. Country risk, stock selection, country 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?

  38. The Case of Turkey: Cultural Differences or Financially, Politically and Economically too unstable?

  39. Fundamentals (Beta, size, P/B)?

  40. Or country specific (Economic, Financial, Political)?

  41. Indeed…

  42. Mikhail Khodorkovsky, Oligarch. Shareholder and former CEO of Yukos oil company. Sentenced to 8 years in prison Russia Political Risk Stock Index

  43. Russia: Impact 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

  44. Brazil Political risk Financial Risk Luiz Inácio Lula da SilvaPresident of Brazil Has improved economy against expectations. Not directly implicated in recent corruption scandal Economic Risk Stock Index

  45. Brazil: Impact 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

  46. Venezuela: Watch for a Nut Case

  47. ConclusionEvolution 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

  48. Asset Allocation Strategies Slow evolving weights Constant weights Dynamic weights Strategic Tactical Conditional Unconditional

  49. Implication on Portfolio management: Conditioning Information and Portfolio Analysis Er Add conditioning information and weights change through time. Frontier shifts. Traditional fixed weight optimization (contrarian) in 2-dimensional setting Vol • Conditioning information makes a difference Adding conditioning information is like adding extra assets to an optimization

  50. China Political risk • 9,5% real growth • 35% export growth • 50% of GDP invested each year Stock Index Financial Risk Economic Risk

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