emerging financial markets lecture 2: market overview

Yale School of Management

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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


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•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)

What is an Emerging Market?


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The Emerging Markets

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US UK

Germ

any

Franc

e

Japa

n

Russia

Argenti

na

Brazil

Mex

ico India

South

Afri

ca

China

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10

15

20

25

30

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US UK

Germ

any

Franc

e

Japa

n

Russia

Argenti

na

Brazil

Mex

ico India

South

Afri

ca

China

1913

2000

Integration Index =Country’s share in world Invesment stocks

Country’s share in World GDP

Share of world GDP (in ppp, Share of world GDP (in ppp, 1990 international dollars)1990 international dollars)

Share of international investment Share of international investment stocks in 1913 and 2000stocks in 1913 and 2000

Integration IndexIntegration Index


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Financial Markets also emerge, submerge and re-emerge

Argentina’s stock market:

Founded in 1872Submerged in 1965Re-emerged in 1975

Peru: 1941-52, 57-77, 88-


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Table. PRODUCTIVITY GROWTH

Time Taken to Double Per-capita Output (Selected periods)

Country Period Years

China 1977-1987 10

South korea 1966-1977 11

Brazil 1961-1979 19

Turkey 1857-1877 20

Japan 1855-1919 34

U.S. 1839-1886 48

U.K. 1780-1838 59

Sources: For U.K., Crafts 1981; for Japan, Moddison, for others, World Bank data


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

-0.80%

2.50%

3.40%

8.80%

9.80%

10.20%

10.40%

11.60%

17.80%

22.50%

24.10%

-5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Taiwan

Malaysia

Singapore

Hong Kong

US

Chile

China

Argentina

India

Brazil

Mexico


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Major Emerging Equity Markets

Rank MKt MCP Rank Mkt TVol Rank Mkt Nlist

1 US 11.3 1 US 10.2 1 US 8851

10 HK 0.41 2 TW 1.2 2 IN 5843

13 TW 0.28 7 HK 0.48 7 SL 872

15 BR 0.25 10 CH 0.37 8 PK 781

16 SA 0.23 14 BR 0.20 9 KO 776

Note: MKT-market Value, Tvol-Trading Volume, Nlist-Number of listed companies


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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.


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Eun & Jarakiramannan (1986)

Yale School of ManagementNumber of expropriations of foreign assets in different countries: development leading to new

globalization

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


Number of countries expropriating foreign assets

11DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.


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Harvey & Roper (1999)


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


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Mexico: for financial firms


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One Stock, Two Prices

FROM 1-1-99 TO 1-17-01 WEEKLY INDEXED

J F M A M J J A S O N D J F M A M J J A S O N D J50

100

150

200

250

300

350

400

450

500

550

600

TAIWAN SEMICON.SPN.ADR 1 ADR = 5 SHARESTAIWAN SEMICON.MNFG.

HIGH 580.42 2-4-00 LOW 100.00 1-1-99 LAST 248.34HIGH 379.39 2-11-00 LOW 100.00 1-1-99 LAST 208.44Source: DATASTREAM


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Accounting issues

Poor financial accounting: hard to

value assets

Are accountings numbers useless?

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Table 1: Original Balance Sheets

Company A Company BCash: 100 Cash: 100Real Asset: 100 Equity: 200 Real Asset: 100 Equity: 200Shares Outstanding :200 Shares Outstanding :200Book Value per share: 1.00 Book Value per share: 1.00

Table 2: Balance Sheet when A Buys 100 of B's stock

Company A Company BCash: 0 Cash: 200Real Asset: 100 Equity: 200 Real Asset: 100 Equity: 300Investment: 100Shares Outstanding :200 Shares Outstanding :300Book Value per share: 1.00 Book Value per share: 1.00

How do you handle cross-holding of shares?


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Table 3: Balance Sheet with 200 in Total Cross Holdings

Company A Company BCash: 100 Cash: 100Real Asset: 100 Equity: 300 Real Asset: 100 Equity: 300Investment: 100 Investment: 100Shares Outstanding: 300 Shares Outstanding: 300Book Value per share: 1.00 Book Value per share: 1.00

Table 4: Balance Sheet with 3600 in Total Cross Holdings

Company A Company BCash: 100 Cash: 100Real Asset: 100 Equity: 2000 Real Asset: 100 Equity: 2000Investment: 1800 Investment: 1800Shares Outstanding: 2000 Shares Outstanding: 2000Book Value per share: 1.00 Book Value per share: 1.00


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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.


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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.


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Summary Statistics-April 1991 - March 1996

Country Start DateArithemetic

ReturnGeometric

ReturnStandarddeviation Skewness Kurtosis

NomalityTest

P-value

FirstOrder

Autocorrel

BetaMSCIWorld

BetaMSCI

AC World

BetaIFCG

CompositeArgentina Apr-91 35.5% 25.6% 56.7% 3.09 16.92 0.00 0.06 1.53 1.69 0.91Brazil Apr-91 44.3% 37.1% 52.2% 0.89 1.51 0.00 0.09 1.19 1.43 1.38Chile Apr-91 24.7% 23.6% 26.6% 0.35 -0.43 0.04 0.23 0.09 0.20 0.64Colombia Apr-91 40.5% 39.0% 40.1% 1.33 2.02 0.00 0.54 -0.05 -0.01 0.25Greece Apr-91 -2.7% -5.5% 24.1% -0.34 0.06 0.32 0.16 0.52 0.54 0.28India Apr-91 12.6% 6.3% 36.8% 0.67 1.47 0.20 0.25 -0.60 -0.49 0.69Indonesia Apr-91 9.5% 5.5% 29.2% 0.15 0.09 0.83 0.18 0.58 0.72 1.04Jordan Apr-91 10.0% 9.4% 14.3% 0.34 -0.80 0.00 0.07 0.11 0.13 0.11Malaysia Apr-91 20.4% 19.1% 23.9% -0.06 1.03 0.26 -0.16 0.57 0.67 0.87Mexico Apr-91 15.7% 8.5% 37.5% -1.01 2.04 0.09 0.33 0.83 1.08 1.40Nigeria Apr-91 37.5% 12.7% 69.5% 1.19 11.92 0.00 -0.04 1.15 1.14 -0.05Pakistan Apr-91 22.4% 18.1% 35.3% 1.03 1.92 0.01 0.30 0.06 0.15 0.57Philippines Apr-91 24.1% 22.4% 28.7% 1.37 4.47 0.18 0.02 0.54 0.69 1.10Portugal Apr-91 8.3% 6.6% 19.6% 0.41 1.55 0.29 0.01 0.98 1.01 0.25S. Korea Apr-91 7.8% 4.7% 26.0% 1.07 1.75 0.03 0.04 0.41 0.51 0.68Taiwan Apr-91 7.3% 1.4% 37.1% 2.24 7.65 0.00 0.08 0.69 0.88 1.42Thailand Apr-91 20.1% 17.2% 30.0% 1.08 1.85 0.03 0.03 0.20 0.35 1.14Turkey Apr-91 13.6% -3.9% 61.2% 0.64 0.42 0.04 0.08 -0.12 -0.01 0.87Venezuela Apr-91 -7.0% -16.8% 45.8% -0.45 1.91 0.24 -0.25 0.45 0.54 0.57Zimbabwe Apr-91 4.8% -1.1% 34.9% 0.38 0.87 0.37 0.32 0.84 0.90 0.55MSCI World Apr-91 11.2% 11.1% 10.7% -0.32 -0.34 0.08 -0.25 1.00 1.01 0.20MSCI AC W’d Apr-91 11.0% 11.0% 10.5% -0.23 -0.39 0.14 -0.22 0.98 1.00 0.25IFCG Comp. Apr-91 11.4% 10.6% 16.4% 0.93 3.47 0.08 0.40 0.47 0.62 1.00*Composite: IFC Global Composite; AC World: MSCI All Country Index. Source: IFC Global Indices, MSCI Indices. Monthly returns in US Dollars.Source: Erb, Harvey and Viskanta


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Crises tend to occur often in EM


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TAIWAN SE WEIGHTED - PRICE INDEXFROM 1-1-87 TO 1-22-01 MONTHLY

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

000'S

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12

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Source: DATASTREAM

Speculations in EM lead to more frequent crises


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FROM 1-4-88 TO 3-31-99 MONTHLY

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 19990

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80

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TAIWAN-DS MARKET - DIVIDEND YIELDTAIWAN-DS MARKET - PER

HIGH 2.31 10-4-90 LOW 0.42 9-2-88 LAST 1.59HIGH 87.5 9-2-88 LOW 16.0 10-4-90 LAST 19.6 Source: DATASTREAM

PE and Dividend Yield in Taiwan


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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


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

Indonesia

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

94 95 96 97

Vo

lati

lity

Indonesia


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

9495

96

97

Indonesia

Korea

Brazil

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Indonesia

Korea

Brazil


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

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Regression Of Returns On Country Variables

Var Coef t-Stat

Constant 0.009 0.068

Freedom

Index

0.004 0.106

GDP

Growth(%)

0.008 1.180

Rule of Law 0.026 2.240

IICCR -0.003 -1.507

EM Beta 0.016 0.431

World Beta 0.025 0.614

Volatility 0.718 1.868

R2(adjusted) 0.157


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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


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Average Number of Days Taken to Collect Dividend, 1995(Source: Global Securities Consulting Services, Ltd.)

34.2

16.214.8

6.55.3

4.5

2.5 2.11 0.7

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Philippines India Venezuela Argentina Brazil Thailand Korea UK UnitedStates

Germany


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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.


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


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In addition to liquidity issues,

Short-sales may not be allowed in EMs

emerging financial markets lecture 2: market overview

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