Wouter Spieringhs S981617

Table of contents

1 Introduction 2 Defining emerging markets 2.1 Market size and openness 2.2 Market efficiency 2.3 Market liquidity 2.4 The actual distinction 3 Origin of the risk 3.1 Country risk 3.2 Market risk 3.3 Firm specific risk 4 Consequences of risk 5 Conclusion References

Introduction

Emerging markets are often seen as high expected return opportunities. These high expected returns dont come for free; theyre only this high because of the high risk that they come together with. This paper compares emerging markets with developed markets. With this information it will show where the extra risk in emerging markets come from.

The second section of this paper is an outline of the main differences between emerging and developed markets. The third part shows why the risk is actually higher in emerging markets. Finally the fourth part briefly shows what consequences the higher risk has.

I intentionally did not use the terms volatility and variance in this paper. I realize that this might be controversial since this paper is about risk. The main reason I didnt use the terms is that this paper covers the origin of the extra risk in emerging markets and it does not cover the calculations of it.

Defining emerging markets

A market is identified by different characteristics. With these characteristics it is possible to distinguish emerging markets from developed markets. According to Li and Hoyer-Ellefsen (2006) these characteristics can be best divided in three categories: 1) Market size and openness; 2) Market efficiency; 3) Market liquidity.

2.1

Market size and openness

A nations market size is measured by the stock market capitalisation. Obviously the size of a capital market itself is no indicator whether a market is developed or still emerging. What does matter is the market size relative to its nations Gross Domestic Product (GDP). A nations market capitalisation divided by its GDP shows the average market capitalisation. This average market capitalisation itself does not clearly show the difference between emerging and developed markets, though in general the average market capitalisation of emerging markets is lower compared to developed markets. The Gross National Product (GNP) per capita is not a measure for the market size but for the overall economy. With almost no exceptions countries with a developed market have a significant higher GNP per capita compared to countries with an emerging market.

The market openness is a measurement of how accessible a market is for foreign investors. Ideally a country has no limitations at all. Often emerging markets are limited in one or more ways. These limitations can be set either by law or by any individual company. Possible restrictions are limitations on total foreign ownership or ownership per foreign shareholder. The most extreme example of a closed market is a country denying access to all foreign investors.

2.2

Market efficiency

For a market to work efficient it depends on information. Very much information is needed on capital markets. When this information is of a good quality it is possible for investors to monitor companies and create reliable expectations. It is vital that any new information is processed instantaneous. Another requirement for stocks to be priced efficiently is that any new information is brought to the market unbiased. When these criteria are met the market is called transparent. Inefficient markets result in more risk for investors. Because of the higher risk investors require higher returns, which results in a less efficient way of allocating capital on the market.

2.3

Market liquidity

A market with a poor liquidity may bring several problems. First of all it may be difficult to sell a stock. In developed markets the turnover rate is high enough to make sure selling large quantities of stocks is no problem. In emerging markets however, the lack of liquidity can make it hard to get out of investments. Another problem in emerging markets is that large transactions may influence the stocks price, which obviously is very undesirable. The liquidity of a market can be measured by looking at how many stocks are traded daily and how much the total value of the traded stocks is.

2.4

The actual distinction

With any of the previous shown indicators individually its not possible to define a market as emerging or developed. Even though the given characteristics dont show whether a market is considered emerging or developed, looking at the combined characteristics for a country may give a good impression to what extend the countries financial market is expanded towards being fully developed.

Origin of the risk

Emerging markets have several extra or bigger risk factors compared to developed markets. This extra risk is not just explained by the fact that emerging markets are in general weaker economies. In short, the differences shown in the previous part of this paper are the foundation for the increased risk. It is possible to make a clear outline by specifying risks in these three categories: 1) Country/political risk; 2) Market risk; 3) Firm-specific risk.

3.1

Country risk

Governments of economically weak countries often have trouble borrowing. A lack of creditworthiness results in high rates when issuing bonds. This means that by looking at the rates of government bonds it is possible to get a fairly good perception of a countrys base risk. It is important to note that a lack of available government bonds can mean the default risk is exceptional high, which might result in rates unacceptable for either the issuing government or the investors. However, it is also possible that a lack of available bonds indicates that the government wasnt in need of money, possibly due to surpluses. The borrowing rates of a government are of great influence on the borrowing rates of companies in its country. The sovereign ceiling is a rule that says it is impossible for a corporation to have a debt with a higher rating then its government. Even though it is debatable whether or not this rule is of any value (why couldnt a company be more creditworthy then its government?), it doesnt change the fact that the borrowing rates of a government are of great influence on the borrowing rates of companies in its country.

Another way governments have something to do with the risk profile of companies in their country is by the laws it keeps. By creating and maintaining laws governments have influence on both companies and capital markets. An important part of legislation is the auditing and the periodical reporting of companies. When a government has set up effective laws and is capable of executing them, the risk for investors reduces. The government influence on capital

markets is also enforced through legislation. As noted earlier, governments can hinder or even deny foreign investors on their market. By (partly) closing their market the allocation of money becomes less efficient.

Yet another political risk is the countrys stability. Unstable countries that have a chance on a (civil) war or a coup obviously dont have the ideal climate to invest in. It is not always that extreme though. All countries and multinationals suffer from corruption. In general, developed countries endure less from corruption compared to emerging countries and therefore emerging markets suffer more losses. Corruption causes the economy to work less effective.

3.2

Market risk

The (capital) market risk consists of several problems. Emerging markets can be inefficient and immature which causes the market risk to increase. Market risk consists mostly of macro economic factors. The general state of the economy can be a burden on emerging markets. Often developed markets are heavily correlated to each other. Most emerging markets are not nearly as correlated to developed markets as developed markets are between themselves. This is mainly because emerging markets arent integrated very well yet into the developed markets. The result is that bad news from foreign countries has little consequences on the local market. On the other hand, systematic risk depends heavily on their own economic climate. Weak economies tend to have less resistance against bad events which might therefore cause bigger consequences on stock prices. Recessions may have big impacts on the local economy. Other important economic influences are the inflation and exchange rates. Both the inflation and exchange rates tend to be under control in most countries with a developed market while countries with an emerging market often show high inflation and/or unstable exchange rates.

Another market risk is the possibility of changing discount rates. Future cash flows are discounted in stock prices. A change in the discount rate results in a different present value of the future cash flows. A different present value will be processed in the price immediately.

3.3

Firm-specific risk

Firm-specific risk is heavily dependant on information. If the information flow is not optimal for any reason, the risk increases. First of all it is important that theres a lot information about the companies as well as about the market. Without a steady information flow investors and analysts are in the dark. Secondly, the information must be of good quality since investors base their decision making on that information. Thirdly, the information must become public simultaneously for the whole market. Information dropping from one person to another before hitting the news causes unfair trade.

If any of the previous criteria for efficient trade isnt met, investors dont have a good base to work from. Without this base it is a lot harder and maybe even practically impossible to invest in a country.

Other firm-specific risks can be anything, for example a fire on a plant, a form of mismanagement and a lawsuit. These risks often differ for each country depending on legislation. For these examples legislation handles the issues respectively with strict fire precautions, harsh punishments for mismanagement and depending on the lawsuit financial compensations or a strict anti-trust law for instance.

Basically firm-specific risk partly consists of all the risk the firm faces and it is therefore impossible to name all of the factors. As shown in the example a countrys internal circumstances have great influence on the impact of a firms risk. The risk will differ in each country and for each company.

The firm-specific risk is diversifiable and therefore it is possible to decrease the exposure to this type of risk by wisely choosing a portfolio consisting of a wide variety of investments.

Consequences of risk

In general, emerging markets show better expected returns. Because of the higher risk profile compared to developed markets, investors require these higher expected returns. The danger of the higher risk can become evident in anything from disappointing returns up to, in the worst case scenario, default. In the end the higher returns are for paying off the risk. One good example which shows the tremendous effects the high risk emerging markets can cause is the 1994-1995 Mexican peso crash. As Smith and Walter (1997) show:

The collapse of the Mexican peso in late 1994 and early 1995 brought an abrupt end to the euphoria. Emerging market equity securities crashed in a simultaneous pattern all over the world. The IFC Emerging Markets Investible Composite Index measured in U.S. dollars dropped by 12% in calendar 1994 (having risen by 79.6% in 1993, 3.3% in 1992, and 39.5% in 1991). By the end of January 1995, the damage had become far greater. Measured against its level as of January 1, 1994, the stock market in Turkey was down 57%, Mexico 56%, China 54%, Poland 50% and Hong Kong 41%, with plunges of 20% to 30% common in most countries. (The principal exceptions were Chile, where the market was up 42%, Brazil 39%, South Africa 10%, and South Korea 9% over the same period.)

Several conclusions can be drawn from this quote. First of all it clearly shows a part of the extended risk of emerging markets. Developed markets can crash as well of course, but emerging markets have an increased risk because of the unstable economy behind it. In this instance a currency crash started it all but this is just an example. Basically any risk factor described in this paper increases the likelihood of such a crash.

Another interesting point from the Mexican peso crash is that Chile, Brazil, South Africa and South Korea didnt notably suffer. The crash clearly shows that emerging markets arent as correlated to each other as developed markets are. One possible explanation for developed markets being more correlated to each other is that large banks hedge their risk between each other. This means that a major blow in for instance the United States economy can be a blow for all banks in developed markets. Since most leading banks are from countries with developed markets, the emerging markets wouldnt suffer as much.

What does the extended risk mean for the emerging market? First of all the risk on a crash as described is not one to ignore. If such an event happens it sets back the economy and the consequences will be noticeable for years. Another effect from the increased risk for emerging markets is that the capital in these countries is significantly more expensive for their governments compared to other countries. When the capital is more expensive, debts weigh heavier on the countrys budget. The same goes for companies. Their capital is more expensive as well compared to their equivalent in developed markets. This burden is a drawback for their operations and causes a disadvantage compared to similar companies from other countries.

From the investors point of view the risk is acceptable. This can be concluded from the growing investments in emerging markets. The high expected returns can be seen as one motive but certainly not the only one. As mentioned before emerging markets arent nearly correlated as much to developed markets as developed markets are between themselves. Investors can use emerging markets for lowering their portfolio risk because uncorrelated stocks lower the total portfolio volatility.

Conclusion

This paper shows the main differences between emerging and developed markets. Some of these differences can cause additional risk. Even though this paper divided the risk into three categories; country risk, market risk and firm-specific risk, all three interrelate. Even though these three risk factors interrelate it clearly shows how the risk is composed.

Risks in emerging markets clearly are higher compared to developed markets. It is important to stress out that these risks can have huge consequences as can be seen in a number of crises in the past. The Mexican peso crisis mentioned earlier in this paper is just one example but many more have happened and will happen.

Ideally emerging markets should transform into the free-market model as seen in the developed markets. This is not instantly possible though. The transition will take a long time and has to be carried out step by step. The emerging markets do not have a strong economy as a strong backup, therefore it is important to let the capital market and economy grow proportionally. Slowly some emerging markets will approach the developed markets close enough until they become developed themselves. There is a big role for the government in this process. By enforcing limitations for foreign investors the process is slowed down. On the other hand, if the government encourages and regulates trading on the financial markets, capital will be allocated efficiently and this will benefit the economy.

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