RISK IN EMERGING CAPITAL MARKETS

1
RISK IN EMERGING CAPITAL MARKETS

• from a Global Tactical Asset Allocation
  Perspective.

2
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
Emerging Markets Performance Returns
4
Emerging MarketsVolatility
5
Emerging Markets Bullish and Bearish Months
6
Emerging Markets Bullish and Bearish Local
Returns
-100
7
Emerging Markets Bullish and Bearish US Returns
8

Emerging Markets Correlations 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

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Traditional Risk Decomposition
Return Rit rft ai biRmt rft
eit Risk s2i 0 b2 s2m
s2ei
Total Risk Variability s2i

• Market Risk
• b2 s2m
• Beta Risk

Specific Risk s2ei
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 Risk Political, economic, financial risk
11
Emerging Markets RisksWorld Beta?

Incorporating the Asian crisis makes the model
look even worse.
12
Emerging Markets Risks 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
13
Emerging Markets Risks Size, Value,
Investability, liquidity Risks
Size (x 1,000) Size (x 1,000) Price-to-book Price-to-book Investability Investability Turnover 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
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Rethinking Risk in Emerging Markets Return
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
  gainsi.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 marketsi.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 relatedto the
  marginal information associated with
• Trading Risk
• Investable Risk
• Political, economic and financial Risks

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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)

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
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Emerging Markets Risks Trading Risk It has
evolved Cairo and Alexandria Stock Exchange
Period 01/01/98 to 05/31/01 Volatility persistence Expected Volume Unexpected Volume
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)

22
Emerging Markets Risks Trading Risk Istanbul
Stock Exchange

• Girard and Kilmaz (2006)

 1987-1993 Volatility persistence Expected Volume Unexpected Volume
Average 0.7679
Average 0.7949 -0.1067 0.3691
 2000-2005 Volatility persistence Expected Volume Unexpected Volume
Average 0.8905
Average 0.8879 0.0264 0.0846
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.

Investability 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
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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
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Emerging Markets Risks Investable Risk and
Investable Premium
Girard (2006)
Countries Stocks Inv. Stocks N-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
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Emerging Markets Risks Determinants of
investable risk
Local Factors
Girard (2006)
Conflicts rating Corruption rating Investment profile rating Social Tensions rating Law and Order rating Debt Service rating
Investable Premium -0.019 -0.005 -0.005 -0.004 -0.002 0.001
Global Factors
Market Premium Value Premium Size Premium Mom. Premium Investable Premium
Intercept -0.0028 -0.0051 -0.0083 0.0109 -0.0007
World Premium 0.0882 -0.0366 -0.0734 0.0152 0.1411
World Value Premium 0.0161 0.0276 0.1158 0.0356 -0.0869
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Emerging Markets Risks Investable Risk it is
priced!
Girard (2006)
Period Independent variables Standardized coefficients 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
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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

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
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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
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Emerging Markets Risks Country Risk Ratings
predict correlation
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Emerging Markets Risks Country Risk Ratings
explain returns
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Country risk, stock selection, country
allocation 4 examples

• Turkey Too culturally different or financially,
  economically and politically too immature?
• Russia Potentialsby watch Putin
• Brazil surprisingly robust market
• Venezuela How to do bad when everything goes
  well?

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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
DRETURN2 Coefficient t-Statistic Prob.
Intercept 0.02818 0.29 0.7737
DBeta -0.09001 -0.48 0.6327
DPTBV -0.92828 -1.06 0.2947
DSIZE 0.02150 1.59 0.1185
DECONRISK -0.04038 -2.04 0.0474 b
DFINRISK -0.09044 -4.17 0.0001 a
DPOLRISK -0.06276 -1.90 0.065 c
Adjusted R-squared 0.331113
42

• Russia

Mikhail Khodorkovsky, Oligarch. Shareholder and
former CEO of Yukos oil company. Sentenced to 8
years in prison
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 factori.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 Brazili.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

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Venezuela Watch for a Nut Case
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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
Dynamic weights
Constant weights
Strategic
Tactical
Conditional
Unconditional
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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

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China
Political risk

• 9,5 real growth
• 35 export growth
• 50 of GDP invested each year

Stock Index
Financial Risk
Economic Risk
51
China

• 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