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Emerging Financial Markets Lecture 2: Market Overview

Emerging Financial Markets Lecture 2: Market Overview. Topics for today: Trading and return characteristics Ownership limits for foreign investors Accounting issues Liquidity issues and trading costs Short-sale constraints. What is an Emerging Market?.

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Emerging Financial Markets Lecture 2: Market Overview

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  1. Emerging Financial MarketsLecture 2: Market Overview • Topics for today: • Trading and return characteristics • Ownership limits for foreign investors • Accounting issues • Liquidity issues and trading costs • Short-sale constraints

  2. What is an Emerging Market? • The IFC Definition: Income less than $9,000 • 20% GDP, 80% Population, 72% Area, And 16% Market Capitalization in the World (2003) • Higher growth rates & high avg returns in many countries • Time Taken to Double Per capita Output (10 years but unstable) 3

  3. Country’s share in world Invesment stocks Integration Index = Country’s share in World GDP 1913 2000 The Emerging Markets Share of international investment stocks in 1913 and 2000 Share of world GDP (in ppp, 1990 international dollars) Integration Index

  4. Financial Markets also emerge, submerge and re-emerge • Argentina’s stock market: • Founded in 1872 • Submerged in 1965 • Re-emerged in 1975 • Peru: 1941-52, 57-77, 88-

  5. Average Annual Returns for theTwelve Years Ended December 2006Source: International Finance Corporation. Returns include capital gains and dividends.

  6. Major Emerging Equity Markets Note: MKT-market Value, Tvol-Trading Volume, Nlist-Number of listed companies

  7. Various Forms of Capital Controls • Foreign ownership limits are often imposed in EM. • Different class of shares and their pricing: shares for foreign investors may sell at a discount or premium to domestic shares. 6

  8. Eun & Jarakiramannan (1986)

  9. Number of expropriations of foreign assets in different countries: development leading to new globalization DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.

  10. Number of countries expropriating foreign assets DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.

  11. Harvey & Roper (1999)

  12. Harvey & Roper (1999)

  13. Harvey & Roper (1999)

  14. Example: Mexico (Domowitz, Glen and Madhavan (1997)

  15. Mexico: for financial firms

  16. One Stock, Two Prices 6

  17. Accounting issues • Poor financial accounting: hard to value assets • Are accountings numbers useless? 9

  18. How do you handle cross-holding of shares?

  19. Measuring Emerging Market Returns • Local currency returns vs. dollar returns • Arithmetic, geometric, and internal rates of returnGeometric means are always smaller or equal to arithmetic means.If one compounds geometric mean returns, one will always get the actual return during the sample period. • One should use geometric returns in emerging markets due to high volatility. 2

  20. Emerging Market Return Distribution • High Serial Correlations in Short-run. (Basis for Momentum strategies) • Long-term Mean Reversion for many EMs. (Basis for Value strategies) • Excess Skewness and Kurtosis (Fat Tails, high probability for large surprises)Conventional Derivatives Pricing Tends to Under-price in Emerging Markets Due to Excess Kurtosis.

  21. Crises tend to occur often in EM

  22. Speculations in EM lead to more frequent crises

  23. PE and Dividend Yield in Taiwan

  24. The Nature of Market Return Volatility • International Volatility Comparison: EM Could Be 10 Times More Volatile. • Correlation of Market Volatilities (The “Asian flu”: market volatilities tend to increase at the same time.) • A Simple Model of Average Volatility:positively Related to GDP Growth, Negatively Related to IICCR.Systematic Risk: Positively Related to GDP Growth. 3

  25. Time-varying Volatility: Indonesia as an example(S.D. of Monthly Dollar Returns)

  26. Volatility Contagion (S.D. of Monthly Dollar Returns)

  27. Very Weak Relationship Between Beta (EM & world) and Mean Returns (volatilities do better): caution on CAPM 7

  28. Trading and Liquidity Issues in EM • 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. • Front-running: you may be ripped off. 7

  29. Other Trading Costs? (Plexus Group’s findings for U.S.)

  30. In addition to liquidity issues, Short-sales may not be allowed in EMs

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