1

RISK IN EMERGING CAPITAL RISK IN EMERGING CAPITAL MARKETSMARKETS

…from a Global Tactical Asset Allocation Perspective.

Emerging Capital Markets: DefinitionEmerging Capital Markets: DefinitionShare of World Population, 1996

Emerging84%

Developed16%

Share of World Equity market Capitalization

Emerging9%

Developed91%

The IFC Definition: Income less than $9,000…

Emerging19%

Developed81%

21% of World GDP

85% of the World Population

11% of the World Equity Market Capitalization

Emerging Markets: PerformanceEmerging Markets: Performance Returns Returns

Return per Year (1995-2005)

15%

6%

4%

9%7%

-4%

-5%

0%

5%

10%

15%

20%

ASIA EastEurope

LatinAmerica

MiddleEast and

Africa

AllEmergingMarkets

USA

Emerging MarketsEmerging MarketsVolatilityVolatility

Standard Deviation of Returns per Year (1995-2005)

16%

25%

40%

30%

20%23%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

ASIA EastEurope

LatinAmerica

MiddleEast and

Africa

AllEmergingMarkets

USA

Emerging MarketsEmerging Markets Bullish and Bearish MonthsBullish and Bearish MonthsNumber of Months with Positive and Negative Returns

(1995-2005)

68

78 7681 78 81

64

54 5651 54 51

0

10

20

30

40

50

60

70

80

90

ASIA EastEurope

LatinAmerica

MiddleEast and

Africa

AllEmergingMarkets

USA

Emerging MarketsEmerging Markets Bullish and Bearish Local ReturnsBullish and Bearish Local Returns

Annual Returns during Bullish and Bearish Markets (1995-2005)

66%

100%

58% 67% 61%31%

-69%

-108%

-61%

-95%

-67%

-36%

-150%

-100%

-50%

0%

50%

100%

150%

ASIA EastEurope

LatinAmerica

MiddleEast and

Africa

AllEmergingMarkets

USA

-100%

Emerging MarketsEmerging Markets Bullish and Bearish US ReturnsBullish and Bearish US Returns

-60

-40

-20

0

20

40

60

US+ geometric mean US- geometric mean

Average Returns During U.S. Up and Down Markets

-60

-40

-20

0

20

40

60

US+ geometric mean US- geometric mean

Average Returns During U.S. Up and Down Markets

AnnualReturnU.S. $

-0.10

0.10.20.30.40.50.60.70.80.9

Since 1980 Since 1990

Emerging MarketsEmerging Markets Correlations with World ReturnsCorrelations with World Returns

-0.10

0.10.20.30.40.50.60.70.80.9

Value

– Liquidity– Repatriation

Limits

– Systematic– Currency– Information– Sovereign/

Credit Risk

– Currency Translation

– Accounting Adjustments

– Taxes

Cash Flow Timing Return Risk

International Stock and Country SelectionInternational Stock and Country SelectionA critical component of stock valuation in international context is knowing the appropriate “required rate of return”.

Traditional Risk DecompositionTraditional Risk Decomposition

Total Risk

Variability 2i

Market Risk

2 2m

•Beta Risk

Specific Risk

2ei

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 RiskPolitical, economic,

financial risk

Return: Rit – rft = i + i[Rmt – rft] + eit

Risk: 2i = 0 + 2 2

m + 2ei

Returns and Beta from 1990 through 1998:03

R2 = 0.1064

-0.2

-0.1

0

0.1

0.2

0.3

0.4

-0.5 0 0.5 1 1.5 2

Beta

Ave

rage

ret

urns

Incorporating the Asian crisis makes the model look even worse.

Emerging Markets RisksEmerging Markets RisksWorldWorld Beta? Beta?

Emerging Markets RisksEmerging Markets Risks Local Beta?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***

Emerging Markets RisksEmerging Markets Risks Size, Value, Investability, liquidity RisksSize, Value, Investability, liquidity Risks

Size (x $1,000) Price-to-book Investability 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

Rethinking Risk in Emerging MarketsRethinking Risk in Emerging Markets Return DistributionReturn 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

Returns, variance and kurtosis…Returns, variance and kurtosis…

0

5

10

15

Variance

- 2

- 1

0

1

2

Skewness

5

7.5

10

12.5

Expected Return

0

5

10

15

Variance

Source: Harvey and Siddique (2000)

or Kurtosis

Developed versus Emerging markets: SkewnessDeveloped versus Emerging markets: Skewness

-2

-1.5

-1

-0.5

0

0.5

1

Average Skewness in Developed Markets

Data from MSCI

-2

-1.5

-1

-0.5

0

0.5

1

Average Skewness in Emerging Markets

-1

0

1

2

3

4

5

6

Average Excess Kurtosis in Developed Markets

Developed versus Emerging markets: KurtosisDeveloped versus Emerging markets: Kurtosis

Data from MSCI

-1

0

1

2

3

4

5

6

Average Excess 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

Sources of excess Variance, Skewness and Kurtosis in Emerging Markets…

Emerging Markets Risks Emerging Markets Risks Trading RiskTrading 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

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.

Emerging Markets Risks Emerging Markets Risks Trading Risk (Information content of intraday Trading Risk (Information content of intraday

trading…)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

Emerging Markets Risks Emerging Markets Risks Trading Risk: It has evolved– Cairo and Trading Risk: It has evolved– Cairo and

Alexandria Stock ExchangeAlexandria Stock Exchange

Period: 01/01/98 to 05/31/01

Volatilitypersistence

Expected Volume

UnexpectedVolume

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)

Emerging Markets Risks Emerging Markets Risks Trading Risk: Istanbul Stock ExchangeTrading Risk: Istanbul Stock Exchange

 1987-1993Volatility

persistenceExpected Volume

UnexpectedVolume

Average 0.7679Average 0.7949 -0.1067 0.3691

 2000-2005Volatility

persistenceExpected Volume

UnexpectedVolume

Average 0.8905Average 0.8879 0.0264 0.0846

Girard and Kilmaz (2006)

Emerging Markets Risks Emerging Markets Risks Investable Risk: Foreign Ownership controlInvestable 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

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

The Effect of LiberalizationThe Effect of Liberalization

Prices

High Expected Announcement Implementation Low ExpectedReturns of Liberalization Returns

PI

PS

Time

Segmented Integrated

Asset Prices and Market Integration

Return to Integration

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60Pre Post

Average Annual Geometric Returns

Evidence: Stock Markets Returns After Evidence: Stock Markets Returns After LiberalizationLiberalization

Standard Deviation of GDP Growth Rates1980-2000

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

ARGBRA

CHLGRC

IND

KORM

EXZAF

THAZW

ECOL

JOR

MYS

NGAPAK

PHLVEN

IDN

PRTTUR

NZLESP

JPN

LKA

Average

Stan

dard

dev

iati

on

Pre-liberalization Post-liberalization

Stock Markets Volatility After LiberalizationStock Markets Volatility After Liberalization

-0.10-0.050.000.050.100.150.200.250.300.350.400.45 Pre Post

Correlation with World

Stock Markets Correlation After LiberalizationStock Markets Correlation After Liberalization

Emerging Markets Risks Emerging Markets Risks Investable Risk and Investable PremiumInvestable Risk and Investable Premium

CountriesStocksInv.

StocksN-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%

Girard (2006)

Emerging Markets Risks Emerging Markets Risks Determinants of investable risk…Determinants of investable risk…

Conflictsrating

Corruptionrating

Investment profile

rating

SocialTensionsrating

Law andOrderrating

DebtServicerating

InvestablePremium -0.019*** -0.005*** -0.005*** -0.004*** -0.002 0.001

MarketPremium

Value Premium

Size Premium

Mom.Premium

InvestablePremium

Intercept -0.0028*** -0.0051*** -0.0083*** 0.0109*** -0.0007

World Premium

0.0882 -0.0366 -0.0734 0.0152 0.1411***

WorldValue Premium

0.0161 0.0276 0.1158 0.0356 -0.0869**

Local Factors

Global Factors

Girard (2006)

Emerging Markets Risks Emerging Markets Risks Investable Risk: it is priced!Investable Risk: it is priced!

PeriodIndependent variables

Standardizedcoefficients

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***

Girard (2006)

– 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

Emerging Markets Risks Emerging Markets Risks Country RiskCountry 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

Emerging Markets Risks Emerging Markets Risks Country Risk Ratings predict inflation

00.1

0.20.30.40.5

0.60.70.8

0.91

0 20 40 60 80 100

Composite Rating

Infla

tion

expe

ctat

ions

for

1997

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

$0

$5,000

$10,000

$15,000

$20,000

$25,000

0 20 40 60 80 100

Composite ratings for 74 countries

Per

cap

ita

real

GD

P

Emerging Markets Risks Emerging Markets Risks Country Risk Ratings predict volatility

R2 = 0.5033

0%

10%

20%

30%

40%

50%

60%

70%

0 20 40 60 80 100

Composite Country Credit Rating

An

nu

ali

zed

Vo

lati

lity

Emerging Markets Risks Emerging Markets Risks Country Risk Ratings predict correlation

R2 = 0.6809

-20%

0%

20%

40%

60%

80%

100%

0 20 40 60 80 100

Institutional Investor Countyr Credit Rating

Co

rrel

ati

on

wit

h M

SC

I A

C W

orl

d

R2 = 0.2976

-10%

0%

10%

20%

30%

40%

50%

0 10 20 30 40 50 60 70 80 90 100

Composite Rating

Ave

rage

retu

rns

Emerging Markets Risks Emerging Markets Risks Country Risk Ratings explain returns

Country risk, stock selection, country Country risk, stock selection, country allocation: 4 examples…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?

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

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

2000 2001 2002 2003

RET_CZECHRET_ESTONIARET_EUROPERET_HUNGARYRET_LATVIA

RET_LITHUANIARET_POLANDRET_SLOVAKIARET_SLOVENIARET_TURKEY

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

0

1

2

3

4

5

6

7

8

9

2000 2001 2002 2003

PB_CZECHPB_ESTONIAPB_EUROPEPB_HUNGARYPB_LATVIA

PB_LITHUANIAPB_POLANDPB_SLOVAKIAPB_SLOVENIAPB_TURKEY

0.0

0.2

0.4

0.6

0.8

1.0

1.2

2000 2001 2002 2003

MKTBETA_CZECHMKTBETA_ESTONIAMKTBETA_EUROPEMKTBETA_HUNGARYMKTBETA_LATVIA

MKTBETA_LITHUANIAMKTBETA_POLANDMKTBETA_SLOVAKIAMKTBETA_SLOVENIAMKTBETA_TURKEY

0

400

800

1200

1600

2000

2400

2800

2000 2001 2002 2003

SIZE_CZECHSIZE_ESTONIASIZE_EUROPESIZE_HUNGARYSIZE_LATVIA

SIZE_LITHUANIASIZE_POLANDSIZE_SLOVAKIASIZE_SLOVENIASIZE_TURKEY

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

-4

-3

-2

-1

0

1

2

2000 2001 2002 2003

ECONRZ_CZECHECONRZ_ESTONIAECONRZ_EUROPEECONRZ_HUNGARYECONRZ_LATVIA

ECONRZ_LITHUANIAECONRZ_POLANDECONRZ_SLOVAKIAECONRZ_SLOVENIAECONRZ_TURKEY

-3

-2

-1

0

1

2

2000 2001 2002 2003

FINRZ_CZECHFINRZ_ESTONIAFINRZ_EUROPEFINRZ_HUNGARYFINRZ_LATVIA

FINRZ_LITHUANIAFINRZ_POLANDFINRZ_SLOVAKIAFINRZ_SLOVENIAFINRZ_TURKEY

-3

-2

-1

0

1

2

2000 2001 2002 2003

POLRZ_CZECHPOLRZ_ESTONIAPOLRZ_EUROPEPOLRZ_HUNGARYPOLRZ_LATVIA

POLRZ_LITHUANIAPOLRZ_POLANDPOLRZ_SLOVAKIAPOLRZ_SLOVENIAPOLRZ_TURKEY

Indeed…Indeed…

RETURN2 Coefficient t-Statistic Prob.

Intercept 0.02818 0.29 0.7737

Beta -0.09001 -0.48 0.6327

PTBV -0.92828 -1.06 0.2947

SIZE 0.02150 1.59 0.1185

ECONRISK -0.04038 -2.04 0.0474 b

FINRISK -0.09044 -4.17 0.0001 a

POLRISK -0.06276 -1.90 0.065 c

Adjusted R-squared 0.331113

Russia

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

0

200

400

600

800

1000

1200

1400

0

10

20

30

40

50

60

70

80

Political Risk

Stock Index

Russia: Russia: Impact of politics on investment policyImpact 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

BrazilBrazil

Luiz Inácio Lula da SilvaLuiz Inácio Lula da SilvaPresident of BrazilPresident of Brazil

Has Has improvedimproved economy economyagainst expectations. Not against expectations. Not directly implicated in recent directly implicated in recent corruption scandalcorruption scandal

0

10

20

30

40

50

60

70

80

0

100

200

300

400

500

600

Political risk

Stock Index

Financial Risk

Economic Risk

Brazil: Brazil: Impact of politics on investment policyImpact 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

Venezuela:Venezuela: Watch for Watch for a Nut Casea Nut Case

0

100

200

300

400

500

600

700

800

900

1000

0

10

20

30

40

50

60

70

80

Chavez is elected

ConclusionConclusionEvolution of Integration and International ValueEvolution 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

Strategic Tactical

Unconditional Conditional

Slow evolvingweights

Dynamicweights

Constantweights

Asset Allocation StrategiesAsset Allocation Strategies

Implication on Portfolio management: Implication on Portfolio management: Conditioning Information and Portfolio Conditioning Information and Portfolio AnalysisAnalysis

Er

Vol

Add conditioninginformation and weightschange through time. Frontier shifts.

Traditional fixed weightoptimization (contrarian)in 2-dimensional setting

• Conditioning information makes a difference Adding conditioning information is like adding extra assets to an optimization

ChinaChina

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

0

50

100

150

200

250

25

30

35

40

45

50

55

60

65

70

75

Political risk

Financial Risk

Economic Risk

Stock Index

ChinaChina 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