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Emerging Markets: Overview and Performance Analysis

  • Mohamed El Hedi Arouri
  • Fredj Jawadi
  • Duc Khuong Nguyen
Chapter
Part of the Contributions to Management Science book series (MANAGEMENT SC.)

Abstract

Emerging markets have become increasingly important in international portfolio management and world financial system. They now represent a dynamic set of investment opportunities for both individual and institutional investors. Although much has been learned about emerging market finance, these markets still pose challenges for finance studies as standard models are often ill suited to deal with their specific characteristics.

The purpose of this chapter is to provide a comprehensive review of emerging markets through presenting their qualitative and quantitative characteristics. The focus is also put on the ways for foreign investors to gain access to these markets as well as on country and specific risks because their assessment affects, to a large extent, international investment decisions.

Keywords

Stock Market Foreign Investor Equity Market International Bond Political Risk 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

1.1 Basics of Emerging Markets

The importance of emerging financial markets in international portfolio diversification was initially evoked by Grubel (1968), Levy and Sarnat (1970) and Errunza (1977). Accordingly, the inclusion of the assets issued by these markets helps to improve the mean-variance performance of an internationally diversified portfolio due particularly to their low correlation with others of the world. High potential of expected returns coupled with high volatility is another financial attribute of emerging markets.

In the course of their rapid development and maturation over the last three decades following the implementation of numerous economic reforms, two intriguing questions arise outstandingly. Which are the specific features of emerging markets? And how far these markets can distinguish themselves from financial markets of developed and developing countries? Answering these questions then allows for a better understanding of emerging market nature and interests, which in turn renders possible the specification of well suitable models to explain the dynamic evolution of risks and rewards in these markets.

1.1.1 The Concept of Emerging Markets

The term “emerging markets” appeared in the beginning of the 1980s and was initially used to designate financial markets located in developing countries according to the World Bank’s country classification. Indeed, all economies with low and middle Gross National Income (GNI) per capita are classified as developing countries.1 However, not all financial markets in developing countries are considered as emerging markets since there is actually a category of less developed countries (Ethiopia, Cambodia, Ghana, Laos, Uganda, etc.) whose financial markets are still very embryonic and small. It is thus clear that income criterion might create confusion when defining emerging markets.

In 1981, the International Finance Corporation (IFC) proceeded to an explicit distinction between emerging and developing countries.2 The criteria used by the IFC to attribute emerging status include not only income criterion, but also stock market’s size, level of development and degree of openings. Overall, a market is said to be emerging if it meets the following conditions:
  • It is located in a developing country as defined by the World Bank. The country is further characterized by a high potential for economic growth, a relative stability of the macroeconomic and political prospects as well as a sweeping process of economic and financial reforms.

  • The stock market experiences significant changes in terms of its relative size (capitalization) compared to GDP, trading activities, and liquidity and sophistication levels.

  • The stock market must be relatively liquid and reasonably accessible to foreign investors. In general, one can rely on the relative importance of investable market capitalization over GDP to appreciate the degree of accessibility. Note that the investable market capitalization refers to the portion of total market capitalization after excluding all block holdings and parts of listed companies inaccessible due to foreign ownership limits.

  • Other qualitative features including for example capital controls, operational efficiency, quality of market regulation relating to accounting standards and financial reporting principles, corporate governance practices, and minority investor rights are also considered when analyzing specific market.

By the end of 2008, the world’s leading provider of credit ratings, risk management services and indices Standard and Poor’s has identified and admitted 34 emerging markets in its Emerging Market Database (EMDB).3 For each emerging market, two families of indices are constructed: S&P/IFCG (Global) which covers a market capitalization target of 70–80% of the whole market capitalization, and S&P/IFCI (Investable) which refers to the investable part (nonrestricted holding blocks available to foreign investors) of the market capitalization of the constituent members of the S&P/IFCG. S&P covers, in addition, 24 lesser developed markets even by emerging market standards, called “frontier emerging markets”. Apart S&P, the provider of investment decision support tools MSCI Barra (Morgan Stanley Capital International) also calculates market indices for a number of emerging markets. Even though MSCI Barra uses relatively different criteria to identify emerging markets, the index values do not differ across index providers. Financial economists may however prefer the S&P indices in empirical studies because they include the broadest set of emerging markets. Table 1.1 shows the complete list of emerging and frontier markets surveyed by S&P as well as emerging markets surveyed by MSCI for comparative purpose.
Table 1.1

Emerging and frontier markets surveyed by S&P and MSCI Barra

 

Emerging markets

MSCI Barra

S&P’s frontier emerging markets

 

S&P

 

1

Argentina

 

Bangladesh

2

Bahrain

 

Botswana

3

Brazil

Yes

Bulgaria

4

Chile

Yes

Cote d’Ivoire

5

China

Yes

Croatia

6

Colombia

Yes

Ecuador

7

Czech Republic

Yes

Estonia

8

Egypt

Yes

Ghana

9

Hungary

Yes

Jamaica

10

India

Yes

Kazakhstan

11

Indonesia

Yes

Kenya

12

Israel

Yes

Latvia

13

Jordan

 

Lebanon

14

South Korea

Yes

Lithuania

15

Kuwait

 

Mauritius

16

Malaysia

Yes

Namibia

17

Mexico

Yes

Panama

18

Morocco

Yes

Romania

19

Nigeria

 

Slovak Republic

20

Oman

 

Slovenia

21

Pakistan

 

Tobago & Trinidad

22

Peru

Yes

Tunisia

23

Philippines

Yes

Ukraine

24

Poland

Yes

Vietnam

25

Qatar

  

26

Russia

Yes

 

27

Saudi Arabia

  

28

South Africa

Yes

 

29

Sri Lanka

  

30

Taiwan

Yes

 

31

Thailand

Yes

 

32

Turkey

Yes

 

33

United Arab Emirates

  

34

Zimbabwe

  

Source: S&P Emerging Market Database and MSCI Barra website as of July 19, 2009

It should be finally noted that judgment criteria used by S&P for country inclusion into the EMDB rather focus on stock markets. That is why in practice a country (or an economy) whose stock market meets the S&P’s inclusion criteria is generally referred to as emerging country (or emerging economy). Notice that, in what follows, the generic term “emerging markets” will be also used to designate equity markets in emerging countries.

1.1.2 Dispersions Among Emerging Markets

Emerging markets exhibit much dispersion at the group level, especially in terms of market depth, size and development. First, some markets are much older than the others. Stock markets in Turkey, Brazil and Indonesia were for example established respectively in 1866, 1877 and 1912 whereas Chinese stock markets (Shanghai and Shenzhen) were only created in 1992. Second, the disparity in market capitalization is another outstanding feature. At the end of 2003, the market information reveals that market capitalization of the largest emerging markets such as China and Taiwan reached about $681,204 and $379,023 billion respectively while many other markets including for example Nigeria, Venezuela and Zimbabwe still have a market capitalization less than $10 billion. Finally, the degree of market development also differs significantly across markets of the emerging universe as some matures more rapidly than the others and have been classified as developed markets. For example, Portugal qualified for inclusion into developed market group in March 1999 whereas it was admitted in the EMDB in January 1986. Greece also evolved into developed market in 2001 after being included in the S&P’s EMBD for a very short period of time.

The heterogeneity of emerging markets can be explained by their differences in development stages. A close look at their evolution reveals four distinct stages: an embryonic phase, a phase of low trading activity, an active development phase and maturity phase (Derrabi 1997).

The embryonic phase is typically characterized by the embryo of trading activities, the absence of automatic trading system in stock markets and the irregularity of exchanges (e.g., several trading sessions per day and several trading days per week). Stock markets are not attractive during this phase and display low trading volume and lack of market transparency and market regulation toward listed firms. Almost all actual emerging markets have got over this phase.

Throughout the phase of low trading activity , emerging market governments start opening up their capital markets to foreign capital flows in order to reduce budget deficits and external debts. Many other economic reforms (trade liberalization, privatization, banking system reform, etc.) are also undertaken to improve the functioning, attractiveness and efficiency of stock markets which indeed lead to stimulate the going public (initial public offerings) process of both public and private companies. In addition, market authorities engage actively into regulatory reforms to regulate financial contracts and trading activity.

At the time of the active development phase , emerging countries continue to take sound reform policies in effort to enhance the efficiency of stock markets, information disclosure and market microstructure (automatic and continuous quotation). This phase is also characterized by a reasonable degree of market openings and increasing interests of foreign investors on domestic financial securities. Market indicators such as number of listed companies, liquidity, and capitalization increase remarkably due particularly to the arrival of foreign capital flows. It is important to note that most of emerging markets are currently located at this stage.

The maturity phase is marked by a significant reduction of legal barriers to cross-border investments and specific risks (political, liquidity and currency risks) as a result of regulatory reforms. Some emerging markets have become comparable to developed markets in terms of both market liquidity and operating systems. They further witness some degree of market integration with international capital markets and attract more foreign investors seeking for international diversification benefits. However, they seem to be still vulnerable to external shocks. Examples of emerging markets in maturity phase include Brazil, India, South Korean, Taiwan, and Thailand.

It arises from the above discussions that each emerging market, given its development stage, will have specific characteristics, which typically leads to different set of investment opportunities as well as different behavior in terms of both risk and return of financial assets.

1.1.3 Capital Markets

Emerging capital markets have evolved significantly over the last three decades and are undergoing constant innovation to improve liquidity and market microstructure. Similar to developed markets, they facilitate the allocation of available funds, the raising of capital and the risk sharing both at national and international levels through their increasing integration process to world capital markets. This section aims at describing the recent evolution of domestic capital markets in emerging countries as well as their prospects. A special emphasis is put on the external market financing from the total issuance of bonds, stocks and syndicated loans as it has an important role in market and economic development in emerging countries.

1.1.3.1 Emerging Markets’ Access to External Financing

The recent trends in emerging capital markets in terms of securities issuances are depicted in Fig. 1.1. The emission of bonds and syndicated loans appears to be the principal source of emerging market external financing over the period from 1995 to 2008. The amount of equity issuance still remains low and only exceeds slightly bond issuance in 2007, albeit it experienced steady increase over time.
Fig. 1.1

Recent trends in emerging market external financing

Two main factors explain the success of bond and syndicated loan markets. First, equity shares are exchanged on domestic stock markets and are usually subjected to a wide range of specific market regulations (listing rules, trading limits, compensation payments, etc.) in the country of issuers. Foreign investors may also face ownership restrictions and restricted access as well. It is, however, not the case for bond and international bonds in particular since the latter escapes generally from all specific constraints of the country where bonds are issued. This feature makes bond issuance easier and more advantageous than equity issuance. Second, the existence of discriminatory tax on foreign investments as well as the lack of a reliable and secure investment environment often pushes foreign investors toward alternative financial instruments which have a “global” nature, such as American Depositary Receipts (ADRs), Global Depositary Receipts (GDRs) and Country Funds.

The year-to-year changes in emerging market external financing are also reported in Table 1.2. Several intriguing facts can be noted:
  • The external environment continued to play a crucial role in the developments and financing of emerging markets over time. The total external financing rose by 195.3% from $151.20 billion in 1995 to $446.54 billion in 2008.

  • Foreign investor’s appetite for emerging market assets have been considerably reduced during the periods of high systematic risks. Concrete examples include essentially the Asian financial crisis (1997–1998) where the total external financing decreased by nearly 46%, and the Argentina’s economic crisis in 2001 coupled with rising economic uncertainties due to the effects of terrorist attacks of September 11, 2001 as well as to the bursting of the internet bubbles.

  • The recent breakdown in 2008, i.e., a reduction of 37.67% compared to the 2007 level, is marked by the occurrence of the subprime mortgage market crisis in the US which then spreads quickly to Europe and affects almost all countries. The severity of global recession, the lack of market liquidity and the return of inflation in 2007 are the main risk factors that lead to a sharp decline in external financing of which the most affected segment is equity issuance (73% less than the 2007 level).

Table 1.2

Total value of external financing

Year

Bond issuance

Equity issuance

Syndicated loans

Total

Changes in total issuance value (%)

1995

59.20

10.00

82.00

151.20

1996

103.00

17.80

89.00

209.80

38.76%

1997

126.20

26.20

122.50

274.90

31.03%

1998

79.50

9.40

60.00

148.90

−45.83%

1999

82.40

23.20

58.10

163.70

9.94%

2000

80.50

41.80

94.20

216.50

32.25%

2001

89.00

11.20

61.90

162.10

−25.13%

2002

61.60

16.40

57.60

135.60

−16.35%

2003

97.10

28.00

70.00

195.10

43.88%

2004

128.35

49.03

148.36

325.73

66.96%

2005

179.51

85.43

189.70

454.64

39.58%

2006

163.13

124.92

252.14

540.18

18.82%

2007

184.91

202.35

329.15

716.40

32.62%

2008

106.01

54.25

286.27

446.54

−37.67%

Source: International Capital Markets (IMF, 2001) and Global Financial Stability Report (IMF, 2004, April 2009). Unit: in billions of US dollars

1.1.3.2 Bond Markets

Banks and corporations are major players in bond markets of emerging countries. This type of bonds is however not yet accessible to foreign operators in general. Due to the fierce competition among developing countries for capitals since the beginning of the 1990s, emerging markets had to recourse massively to international bonds in order to get the required capitals for financing their economic development. The majority of international bonds are issued in the forms of foreign bonds and eurobonds.4 This observation explains effectively the increasing share of bond issuance in the total value of emerging market external financing in Table 1.2.

International bonds are particularly advantageous in that they are accessible to all types of investors and they do not depend on any specific regulations of the issuer’s home country. During the 1960s, the main borrowers in international bond markets were local companies in developed countries due to their high credit worthiness. For emerging and developing countries, the access to international bond markets was firstly granted to major emerging markets including Argentina, Brazil, South Korea, Indonesia, Mexico and Thailand. Today, emerging countries that opened up their capital markets to foreigner investors in the 1990s such as Jordan, Sri Lanka, Hungary and Slovakia also get access to these markets. It is finally worth noting that international bonds issued by emerging market issuers have generally a maturity from 2 to 5 years. Some of them can however have a longer maturity which goes up to 17 years.

1.1.3.3 Syndicated Loan Markets

Like eurobonds, syndicated loans or eurocredits are generally underwritten by an international syndicate of banks and denominated in the currencies of developed countries. It is shown in Table 1.2 that emerging markets regained access to syndicated loans in the year of 2000 following dramatic decline caused by the Asian financial crisis. The market for syndicated loan commitments became, for the first time, the most important source of emerging markets’ external financing. The Emerging Asia was the principal recipient of these flows of eurocredits with a total issuance value of $56 billion. Of the remaining $38.2 billion, the Turkish market took $9.5 billion owing to its economic stabilization program undertaken in 2000. For many specialists, the strong liquidity observed was explained by the fact that syndicated loans are less costly, especially in terms of loan application and origination fees, than issued bonds.

It is equally important to note that 2008 was the year that ended the remarkably increasing trends in syndicated loan markets, after surging a noteworthy 370.2% between 2003 and 2007. In light of the unfavorable context in both real and financial sectors of developed countries as well as their own increasing macroeconomic instability in the course of the global financial turmoil, private capital flows to emerging markets and consequently the issuance of eurocredits should experience significant falls.

1.1.3.4 Stock Markets

Emerging stock markets have also experienced significant changes over the recent decades in terms of market size, financial depth and development though they generally attracted less attention from global investors compared to bond and syndicated loan markets. The comparison of key markets indicators in 1990 and 2003 outlines, however, the heterogeneous evolution of the number of listed firms (Fig. 1.2), the transaction volume (Fig. 1.3), and the market capitalization (Fig. 1.4) across selected emerging countries.5 Obviously, some markets have become more mature (e.g., India, South Korea, Taiwan, and Thailand) and very active whereas the others remain still small and illiquid (e.g., Argentina, Colombia, Chile and Venezuela). With an intermediate development level among selected markets, stock markets in Brazil witnessed a striking increase in size from only $16.35 billion in 1990 to $234.56 billion in 2003. Similarly, its liquidity measured by transaction volume in 2003 was 11 times the level in 1990 and attained a yearly level of $60.44 billion. This tendency is also observed for the majority of remaining markets. As it will be discussed further in Chap.  2, this rapid development of emerging markets is primarily due to the adoption of new orientations in economic policies and structural reforms in banking and financial sectors of which financial liberalization is an important component.6
Fig. 1.2

Number of listed firms in selected emerging markets

Fig. 1.3

Trading volume in selected emerging markets

Fig. 1.4

Market size in selected emerging markets

Inside the emerging market universe, market concentration as measured by the market share of the top ten largest firms in terms of market capitalization is still much more stronger than in developed markets. Note that the concentration ratio in developed markets is calculated as the sum of percent market share of the top 5% largest firms.

Another important point to point out is that both bull and bear periods are frequently observed in emerging stock markets. The last serious bear market dated back to the 1997 Asian financial crisis. Their 5 year long bull market (2003–2007) finishes with the recent fall in 2008 due to the global financial panic characterized essentially by extreme risk aversion, liquidity problems, and tight credit conditions. This has resulted in high volatility and financial instability in global emerging markets. Nevertheless, past experiences show that bull markets are typically longer than bear markets, and the average increase during bull markets is relatively more important than the average decline during bear markets. It is generally believed that this pattern tends to be followed in the next decades before the maturity of emerging markets.

1.2 Risk and Return Characteristics of Emerging Stock Markets

Emerging markets are differentiated from developed with respect to several qualitative characteristics such as institutional infrastructure (taxation of dividends and capital gains, capital controls, market regulations and available information flows), market microstructure and market efficiency. The quality of these factors is generally lower for emerging markets than for developed markets. Note that these conditions affect, to the large extent, trading activity, price formulation, and as a result risk-return properties of emerging market assets.

This section turns to shed light on their risk-return characteristics with a particular focus on the equity markets. It permits to justify why emerging markets are considered as an independent and attractive asset class in global portfolio investments. Standard empirical analysis employs MSCI international equity market indices from Datastream International. Sample data are expressed in US dollars to avoid exchange rate effects and include 14 selected emerging stock markets, three emerging regions, G7 market index, and world market index. The study period from December 1992 to June 2009 is chosen to cover the current global financial crisis. Monthly returns are continuously compounded returns.

1.2.1 Risk and Returns

A common consensus rising from past studies is that emerging markets offer higher expected returns supported by their high growth prospects, but they are more volatile than developed markets. This proposition is revisited here using more recent data. Table 1.3 reports the obtained results. It is observed that annualized returns in emerging stock markets range from −3.6% for China to 13.9% for Brazil over the study period. In terms of unconditional volatility, the annualized standard deviations fluctuate between 24.8% for Chile and 57.2% for Turkey. All emerging market return series are significantly skewed and leptokurtic (positive excess kurtosis). In 10 out of 14 emerging markets considered, the skewness coefficients are negative, which typically suggests that large negative returns are more frequent than large positive returns when investing in emerging markets. In other words, significant losses are more likely to realize in extreme situations such as financial turmoil or crisis. The presence of positive kurtosis is however quite appreciated by investor community as it indicates a higher probability of getting positive returns (or large price movement). Unsurprisingly, emerging market returns depart significantly from the normal distribution as shown by the JB statistics.
Table 1.3

Stochastic properties of emerging equity market returns

 

Average returns

Annualized returns

Std. dev.

Annualized volatility

Skew.

Kurt.

JB

Brazil

0.012

0.139

0.120

0.416

−0.848

5.297

67.256

Chile

0.006

0.072

0.072

0.248

−0.959

6.468

129.579

China

−0.003

−0.036

0.109

0.379

0.042

4.036

8.914

Colombia

0.009

0.109

0.096

0.334

−0.430

3.910

12.924

India

0.007

0.079

0.092

0.318

−0.276

3.625

5.731

Malaysia

0.002

0.020

0.093

0.321

−0.155

6.643

110.309

Mexico

0.005

0.064

0.095

0.330

−1.384

6.794

181.924

Philippines

−0.002

-0.020

0.095

0.329

−0.021

5.107

36.631

Poland

0.009

0.109

0.136

0.470

0.525

8.400

249.648

South Africa

0.007

0.081

0.084

0.292

−0.965

5.382

77.536

South Korea

0.004

0.044

0.116

0.402

0.207

5.725

62.697

Taiwan

0.002

0.019

0.093

0.321

0.399

4.309

19.399

Thailand

−0.003

−0.031

0.123

0.425

-0.371

4.829

32.156

Turkey

0.008

0.096

0.165

0.572

−0.337

3.977

11.628

Regional and global indices

EM composite

0.004

0.053

0.073

0.254

−1.204

6.627

156.346

EM Asia

0.002

0.024

0.079

0.274

−0.411

3.759

10.334

EM EME

0.007

0.083

0.083

0.288

−1.195

6.765

164.078

EM Latin America

0.008

0.097

0.089

0.308

−1.299

6.989

186.956

G7 index

0.003

0.036

0.044

0.151

−1.073

5.505

89.757

World index

0.003

0.040

0.045

0.154

−1.141

5.792

107.277

Notes: EM composite, EM Asia, EM EME and EM Latin America denotes MSCI emerging market composite index, and emerging market regional indices for Asia, Europe & Middle East and Latin America. JB denotes the empirical statistics of the Jarque and Bera’s test for normality. Its critical value at 5% level is 5.99. Skew. and Kurt. refer to the skewness and kurtosis coefficients. The total number of monthly observations is 198

Figure 1.5 illustrates the monthly return distribution of two emerging markets: Brazil (negatively skewed distribution) and Taiwan (positively skewed distribution). The case of Taiwanese stock market is more desirable for investors with respect to skewness feature.
Fig. 1.5

Histogram of return distribution in Brazil and Taiwan

When comparing the realized returns to the amount of unconditional volatility, it is important to remark that high volatility in emerging markets is not necessarily accompanied by high expected returns. For example, Turkey experienced highest volatility (57.2% per year), but an annualized returns of 9.6% which is indeed much less than the Brazilian market does over the same period (13.9%) with a volatility of only 41.6% per year. Other disparities exist in terms of risk-return tradeoff for the remaining markets.

At the group level, it appears that on average emerging market composite index and all regional emerging market indices obtained higher annualized returns than the G7 and World market indices (5.3% vs. 3.6% and 4.0% respectively). The reward-to-risk ratio of emerging market composite index stands at 0.21 compared to 0.26 for G7 and world markets, which typically shows an underperformance of emerging markets. Only two emerging regions outperform developed and world market index (Europe & Middle East, and Latin American). The underperformance of the emerging universe is due to the worst returns provided by Asian emerging markets.

Similar analysis is also conducted over two subperiods of equal observations: from January 1993 to February 2001 and from March 2001 to June 2009. The obtained results in Table 1.4 provide evidence of emerging markets’ outperformance in the more recent period as their risk-adjusted performance improves substantially whereas developed equity markets experience negative ratios. This finding is quite interesting and suggestive of the fact that emerging market assets have become recently more mature due to their high return potential and their relatively reduced volatility.
Table 1.4

Comparison of risk-return performance

 

EM composite

EM Asia

EM Latin America

EM Europe &middleeast

World index

G7 index

Jan. 1993 to Feb. 2001

      

Mean

0.001

−0.003

0.005

0.008

0.008

0.008

Std.

0.072

0.083

0.090

0.079

0.038

0.039

Reward-to-riskratio

0.015

−0.034

0.051

0.095

0.220

0.216

Mar. 2001 to Jun. 2009

      

Mean

0.008

0.007

0.011

0.006

−0.002

−0.002

Std.

0.075

0.075

0.088

0.087

0.049

0.048

Reward-to-risk ratio

0.104

0.090

0.130

0.072

−0.034

−0.045

1.2.2 Correlation

Past studies including Harvey (1995a), and Claessens et al. (1995) among others have shown over the 1976–1992 period that emerging markets have low correlations both across markets of the emerging universe and with developed markets. It is worth noting that several emerging markets are even negatively correlated with developed markets.

The pattern of unconditional market linkages has changed dramatically. Tables 1.5 and 1.6 indicate that emerging markets exhibit a positive and moderate correlation between them and with developed markets when monthly data from December 1992 to June 2009 are used. Indeed, the correlation across emerging markets is now far from zero and negative like in historical times. It typically ranges from 0.26 (Colombia/Poland and Philippines/Turkey) to 0.64 (Brazil/Chile and Brazil/Mexico). In addition, the majority of remaining correlation coefficients exceed 0.35 and they are generally higher than 0.45 for markets of the same geographical region.
Table 1.5

Correlations within emerging market universe

 

BRA

CHI

CHI*

COL

IND

MAL

MEX

PHI

POL

SAF

KOR

TAI

THAI

TUR

BRA

1.00

             

CHI

0.64

1.00

            

CHI*

0.47

0.50

1.00

           

COL

0.40

0.43

0.28

1.00

          

IND

0.47

0.52

0.41

0.38

1.00

         

MAL

0.32

0.46

0.47

0.30

0.36

1.00

        

MEX

0.64

0.57

0.46

0.34

0.42

0.36

1.00

       

PHI

0.36

0.51

0.49

0.29

0.33

0.58

0.43

1.00

      

POL

0.47

0.40

0.35

0.26

0.40

0.37

0.52

0.33

1.00

     

SAF

0.54

0.57

0.57

0.34

0.45

0.43

0.56

0.50

0.48

1.00

    

KOR

0.37

0.43

0.36

0.31

0.39

0.37

0.40

0.36

0.40

0.51

1.00

   

TAI

0.47

0.51

0.55

0.30

0.42

0.51

0.45

0.46

0.33

0.51

0.46

1.00

  

THAI

0.42

0.51

0.51

0.29

0.35

0.57

0.45

0.67

0.36

0.61

0.61

0.53

1.00

 

TUR

0.45

0.43

0.33

0.35

0.37

0.28

0.43

0.26

0.36

0.42

0.30

0.33

0.27

1.00

Notes: BRA, CHI, CHI*, COL, IND, MAL, MEX, PHI, POL, SAF, KOR, TAI, and TUR designate respectively Brazil, Chile, China, Colombia, India, Malaysia, Mexico, Philippines, Poland, South Africa, South Korea, Taiwan and Turkey

Table 1.6

Correlations between emerging and developed markets

 

EMcomposite

EM Asia

EM Europe &middleeast

EM Latin America

G7 index

World index

BRA

0.77

0.55

0.64

0.92

0.62

0.63

CHI

0.75

0.64

0.59

0.75

0.57

0.58

CHIN

0.68

0.70

0.47

0.56

0.46

0.48

COL

0.48

0.40

0.41

0.46

0.34

0.36

IND

0.64

0.63

0.52

0.53

0.47

0.48

MAL

0.62

0.74

0.43

0.42

0.40

0.42

MEX

0.78

0.57

0.61

0.85

0.64

0.64

PHI

0.61

0.67

0.37

0.47

0.43

0.45

POL

0.61

0.53

0.56

0.54

0.52

0.54

SAF

0.78

0.68

0.62

0.65

0.63

0.65

KOR

0.62

0.70

0.41

0.45

0.55

0.56

TAI

0.70

0.74

0.49

0.55

0.52

0.53

THAI

0.68

0.76

0.39

0.52

0.50

0.52

TUR

0.58

0.44

0.77

0.51

0.51

0.51

EM Composite

1.00

     

EM Asia

0.90

1.00

    

EM Europe & Middle East

0.81

0.63

1.00

   

EM Latin America

0.90

0.67

0.73

1.00

  

G7 index

0.77

0.67

0.69

0.71

1.00

 

World index

0.80

0.70

0.71

0.73

1.00

1.00

Notes: BRA, CHI, CHI*, COL, IND, MAL, MEX, PHI, POL, SAF, KOR, TAI, and TUR designate respectively Brazil, Chile, China, Colombia, India, Malaysia, Mexico, Philippines, Poland, South Africa, South Korea, Taiwan and Turkey

The correlation of sample emerging markets with MSCI G7 index and MSCI World market index is comprised between 0.34 (Colombia/G7) and 0.65 (South Africa/World). In this scheme of things, actual emerging markets can have a positive and considerable contribution in terms of risk-return tradeoffs of a globally diversified portfolio. Emerging markets with high degree of openness to international capital flows have been found to exhibit relatively high correlation with global equity markets (e.g., Brazil, Mexico, South Africa and South Korea).

The lower part of the correlation matrix in Table 1.6 indicates that emerging markets are now reasonably integrated with global equity markets in the sense that their correlation with G7 and World market indices stands around 0.80, compared to a nearly perfect correlation between G7 and World market indices. All emerging regions are highly correlated with developed world.

Since correlations in international markets tend to increase in times of financial turbulences and crisis, the increases in correlations shown in Tables 1.5 and 1.6 are likely subject to great influences from the recent financial crisis of 2007–2009. However, it is important to stress that the more pronounced correlations between emerging and developed equity markets seem not to be surprising as emerging stock markets are becoming more integrated and the effects of their liberalization policies is becoming more effective in recent years.

1.3 The Process of Market Integration and Risk-return Tradeoff

The analysis of risk-return tradeoff is fundamental to investment decisions. The modern financial theory suggests that expected returns are proportional to the level of risk taken, and as a result investors would prefer an investment project that generates highest rate of return for a given level of risk.

Standard risk-return tradeoff analysis in emerging markets relies particularly on the Capital Asset Pricing Model (CAPM) developed primarily by Sharpe (1964) and Lintner (1965), and the Arbitrage Pricing Theory (APT) developed primarily by Ross (1976). In addition to the determination of relevant risk factors to be included in the asset pricing models in order to accurately describe the dynamics of emerging market returns, empirical studies of the field must also take into account the degree to which emerging markets are integrated with the world equity markets. The rationale is that expected returns would depend only on global risk factors when national markets are entirely integrated with the world market while domestic risk factors are sufficient when national markets are segmented from the world market. In this regard, two main suppositions are frequently examined by past studies focusing on the risk-return relation in emerging markets: complete integration and partial market integration. The complete segmentation hypothesis is intentionally avoided because it appears to be restrictive with respect to an ongoing and active financial liberalization process of emerging markets.

1.3.1 The Case of Complete Integration

In a world of fully integrated markets, assets of the same risk issued in different markets should command identical expected returns. Also, only world risk factors are relevant in explaining the dynamics of expected returns across markets. In the empirical studies relying on the international version of the CAPM (ICAPM), changes in MSCI world market index is often introduced to reflect the worldwide market systematic risk. Empirical results which are controlled for infrequent trading show, however, low significance of the global betas for almost all emerging markets (Harvey 1995b).

The statistical rejection of the single-factor ICAPM leads to think that other factors may be relevant for better capturing the risk-return relation in emerging markets. Two empirical specifications are then proposed:
  • The first one refers to an extension of the ICAPM to a two-factor model in which real exchange rate risk is counted for. Examples include either international asset pricing model of Adler and Dumas (1983) where expected returns in a particular currency is generated by the covariance with the world and the covariances of asset returns and inflation rates in all countries, or a two-factor models of Ferson and Harvey (1994) and Harvey (1995b) where an aggregate index of currency returns is introduced to the single-factor ICAPM.7 The exchange rate factor is however found to have marginal explanatory power over the 1976–1992 period in describing the dynamics of emerging market returns.

  • The second specification is based on a multi-factor model which comprises five systematic risk factors: worldwide market risk, exchange rate risk, changes in commodity prices, inflation rate and world business cycle. With regard to the results, the inclusion of three additional factors does not help to improve the model’s explanatory power, compared to single- and two-factor models.

Overall, empirical findings lead to conclude that either asset pricing models are misspecified or full market integration is not a feasible assumption for emerging markets.

1.3.2 The Case of Partial Market Integration

If financial liberalization is effective, emerging markets are at least partially integrated with world equity markets. In this case, both local and world risk factors are pertinent in pricing emerging market securities. However, the gradual and possibly reverting process of such economic policy, as it will be discussed in Chap.  2, has long posed challenge for the development of dynamic models since inferring emerging market integration from the data is a quite difficult task. On the one hand, emerging markets might remain segmented after liberalization if the removal of regulatory restrictions does not attract foreign investors in the presence of significant indirect barriers. On the other hand, the measure of market integration must be, in some circumstances, time-varying insofar as emerging markets may evolve from the segmented state to integrated state through time and inversely.

Previous studies have mainly adopted two following empirical strategies for modeling return dynamics in partially integrated emerging markets:
  • The development of asset pricing models that take into account investment barriers such as ownership restrictions (Errunza and Losq 1985; Errunza et al. 1992), withholding tax discrimination (Stulz 1981; Wheatley 1988), and information asymmetries (Brennan and Cao 1996).

  • The development of asset pricing models in which two aggregate sources of systematic risks (local and global) are considered. These risks are in general represented by the covariances of asset returns with world and local market index returns. Within this category, empirical measures of market integration can be either invariant (Claessens and Rhee 1994) or time-varying depending on the dynamics of several information variables (Bekaert and Harvey 1995).

Overall, this research stream concludes in favor of significant impacts of international investment barriers and finds evidence of time-varying market integration using emerging market data.

1.4 Specific Risks

Of the emerging market specific risks, political risk, liquidity risk and exchange rate risk are the most watched by investor community as a number of studies have shown that they are priced. In practice, these risks are not specific to emerging markets, but the risk exposure is much higher in emerging markets than in developed markets. The presence of specific risks prevents heavily the willingness of foreign investors to invest in emerging markets.

1.4.1 Political Risk

Political risk refers in general to the combination of political instability (civil war, terrorism, insurrection, political regime change) and unfavorable economic environment (financial instability and growth uncertainty). Like foreign direct investments, portfolio investments are also exposed to nonmarket factors related to political decisions such as economic (e.g., unexpected changes in fiscal, monetary, trade and investment policies) and social policies (labor, social strike, and developmental purposes). Political changes that increase tax discrimination between resident and nonresident investors as well as restrictions on cross-border capital mobility, foreign ownership and exchange-rate movements are particularly faced by foreign portfolio investment flows. Overall disasters that may result from political risk consist mainly of the unwillingness of emerging market governments to honor their sovereign debts, the nationalization of corporations and the impossibility of repatriating both capital and profits.

Assessing the exposure to political risk is notably hard because the methods used, albeit they are very useful for apprehending the nature and evolution of political risk, can neither provide accurate measurements of loss levels given the occurrence of the risks considered and nor be generalized to another country.8 Several international risk services have developed synthetic measure for political risk using various political and economic variables. For instance, the Institutional Investor constructs a country credit rating index which incorporates political risk, while the International Country Risk Guide (ICRG) establishes an individual political risk index of political risk for major emerging market countries. Even though the risk is small in most of the markets, the associated potential loss is large.

To the extent that political risk can significantly dampen the foreign investor’s enthusiasm for international diversification in emerging markets, policymakers should keep an eye on their country’s political situations (Cosset and Suret 1995; Diamonte et al. 1996; Clark and Tunaru 2001).

1.4.2 Liquidity Risk

The liquidity is a primary condition which guarantees the good functioning of financial markets since it eases the trading of financial assets. A liquid market is a market in which assets can be traded at lowest costs without considerable price fluctuation. This market is also characterized by a small spread between asking and selling prices. Accordingly, liquidity risk comes generally from the difficulty or the impossibility of reselling financial assets.

Chuhan (1992) shows that low liquidity was one of the most important barriers that prevents institutional investors from investing in emergent markets. At the macroeconomic level, liquidity risk can result from the fact that short-term external debts in a particular emerging country are not fully covered by its foreign exchange reserves. Note that this imbalance was identified as one of the main reasons that caused the 1994–1995 Latin American crisis and the 1997–1998 Asian financial crisis. Also, government’s controls on the foreign exchange market imply liquidity risk.

1.4.3 Currency Risk

Currency risk refers to the potential value losses due to sudden and strong volatility of exchange rate as well as changes in purchasing power parities. This risk is particularly present in emerging markets as witnessed by their successive currency crisis (currency devaluations) which were frequently twined with banking crisis over the past three decades. For many economists, emerging markets’ currency risk takes its roots in high degree of market openness, specific exchange rate regimes and high macroeconomic uncertainties.

In summary, the above discussions call for a careful analysis of specific risks before making investment decisions. For practical purposes, investors can better apprehend these risks through the use of country risk indices established by, among others, the Economist Intelligence Unit, Euromoney, credit risk rating agencies, the Institutional Investor, and the International Country Risk Guide. The latter provides a composite country risk index from combining its three individual risk indices (political, economic and financial risks).

1.5 Investing in Emerging Markets: Why and How?

Investing in emerging markets encompasses several activities. To carefully define their investment strategies, foreign investors must answer the following questions:
  • What are the benefits of investing in emerging markets?

  • What is the degree of accessibility to foreign investors?

  • How can they invest (entry modes)?

  • What is the future of emerging market investments?

This section aims to bring some answer elements to the above questions based essentially on the qualitative and quantitative analysis of previous sections.

1.5.1 Advantages of Emerging Markets

The motivations for investing in emerging stock markets come from their high growth potential and low correlation with developed markets. Moreover, emerging market asset class represents a dynamic and valuable investment set that matures over time.

1.5.1.1 Risk Diversification Benefits

The modern finance theory suggests that an internationally diversified portfolio offers higher risk-adjusted-return performance than a portfolio composed of only domestic assets. Further, risk diversification can be achieved through investing in uncorrelated or less correlated assets.

Following these theoretical insights, investing in emerging markets is particularly interesting for several reasons. First, emerging markets are characterized by a very low correlation with other markets of the world owing to their numerous restrictions on capital flows from foreign investors. This is entirely supported by the fact that the majority of the correlation coefficients between emerging markets and MSCI World index (as a proxy for global stock market), reported in Sect. 1.2, are less than 35%. Second, the rates of returns in emerging stock markets have been found to be higher than developed markets thanks to the high potential of economic growth that transforms into corporate earnings and dividends. Finally, the higher long-term performance is behind the growing trend toward investing in emerging markets insofar as emerging countries continue to conduct coherent and sound economic reforms. This superior performance is depicted in Fig. 1.6 using three US dollar MSCI total price indices over a 20-year period (MSCI Emerging Markets, MSCI EAFE and MSCI G7).
Fig. 1.6

Long-term performance: emerging versus developed markets

Figure 1.6 shows several attributes of the performance of emerging markets during the recent period of 1988–2008, as follows:
  • MSCI emerging market index (MSCI EM) provided substantially higher returns than the international developed markets represented by both MSCI EAFE and MSCI G7. 9 Indeed, over the period from January 1988 to December 2007, one US dollar invested in MSCI EM capitalized about $12.46. The same one US dollar would bring only $2.97 and $3.57 in December 2007 if it was allocated in MSCI EAFE and MSCI G7 respectively.

  • MSCI EM remarkably outperformed MSCI EAFE and MSCI G7 in almost all times despite harmful effects of several periods of extreme volatility due to financial and currency crises (e.g., Asian crisis in 1997 and Argentina’s debt default in 2001).

  • Recently, the long-term performance of MSCI EM is reduced owing to the current global financial crisis of 2008–2009, but the gap of performance is still large since developed markets have collapsed more dramatically.

1.5.1.2 A More Maturing Asset Class in Emerging Markets

Of course domestic and foreign investors may take some precautions when investing in emerging markets because their high expected returns are usually accompanied by high risks. They have also gone through serious financial crises during the 1980s and 1990s which might lead to dramatic losses and constraint investors to get out of the markets. The analysis in Sect. 1.2 provided however evidence that emerging market asset class becomes more and more mature during the recent period. In particular, the reduced volatility of emerging markets in the last decade has made more attractive their risk-return characteristics. This translates into more sustainable returns that greatly improve their valuations compared to developed markets. Even though higher correlations between emerging and developed markets (due to growing market integration) may diminish diversification benefits of adding emerging asset class, the lower volatility helps to notably reduce portfolio’s marginal risks (i.e., the marginal contribution of an asset’s risk to the total risk of the portfolio).10

It is equally important to note that structural reforms in emerging markets have provided a more stable and credible investment environment while national economies continue to grow at a faster rate (double-digit growth rate in many countries). The most important improvements include the greater transparency in government and corporate practices, the reduction of foreign currency-denominated debts, the exposure to a lower inflation pressure, and the regulatory changes in favor of a more flexibility for international portfolio investments.

1.5.2 Accessibility to Foreign Investors

Although emerging markets offer evident advantages, they are not completely accessible to foreign investors yet. Numerous investment barriers such as entry-exit conditions and capital mobility restrictions are generally imposed to limit foreign participation. More importantly, these obstacles, either direct or indirect can apply to both domestic and foreign investors.

Direct barriers refer to market regulations that control the activities of investment. They include for example discriminatory taxation treatment for foreign investments (dividends and interests), limits on foreign ownership, and restriction on capital gain and interest repatriation. The foreign access to strategic sectors such as defense industry and telecommunications is generally closed or highly controlled. With regard to ownership restrictions, foreign investors are often allowed to hold up to a threshold limit of a domestic company’s equity capital or listed stock of the special share classes dedicated to foreign investors. For example, foreign institutions are authorized to hold without limits only B-share class in China and Malaysia. In South Korea, foreign investors could hold, to the maximum, 10% of a listed firm’s capital as of January 1992. This restriction has been gradually reduced to 12% in January 1995, then 15% in July 1995, and then 18% in April 1996 and finally 20% in October 1996. In Thailand, the banking law restricts the foreign participation to 25% at most of a Thai bank’s capital whereas the Alien Business Act allows a foreign share holding up to 49% of the equity capital of listed companies in other economic sectors at the end of 2003.

Indirect barriers result principally from the overall weakness of market conditions and business environment in emerging markets. In many emerging countries, the lack of good market regulations related to information disclosure and financial reporting, the lack of reliable infrastructure (embryonic private sectors, few financial instruments, specialized portfolio management institutions and unqualified investors) and the absence of international accounting standards and appropriate laws to protect minority shareholders are factors that keep away existing investors and discourage potential investors from investing in emerging markets. Also, the potential vulnerabilities of emerging markets coupled with their exposure to high specific risks including particularly political risk, liquidity risk, and monetary risk affect significantly the willingness of foreign investors to invest in these markets.

Keeping in mind that emerging countries have gradually removed barriers to international investments in effort to make their capital markets more “investable”, the appetite of foreign investors for emerging market assets has grown over time. Nowadays, the access to emerging markets is much easier than 20 years ago so that there is no distinction made between domestic and foreign shareholders. Chap.  2 discusses, in great details, dynamic changes in emerging market access in relation with financial liberalization reforms.

1.5.3 Market Entry Methods

As in developed markets, emerging markets also offer a wide range of financial instruments which can be bought directly from both domestic and foreign investors. Traditional securities and derivatives markets have developed rapidly and provided helpful supports to international trading activities. In particular, massive foreign capital inflows are directed to stock market segments in recent years (see Sect. 1.1.3 for more details).

For a market that still imposes significant restrictions on direct investment in shares, foreign investors can buy sovereign bonds or corporate bonds. Mallat and Nguyen (2008) investigate changes in emerging market sovereign spreads (often used as an indicator of sovereign risk) and find that sovereign risk is reduced significantly following the adhesion of emerging countries into macroeconomic and data transparency standards. In the case of corporate bonds, foreign investors could take advantage of the growth characteristic in emerging markets while eliminating the risk of information asymmetry as these bonds are essentially convertible bonds. The market for derivative instruments are, however, relatively recent for most of emerging markets. In general, they are less sophisticated and less standardized than those in developed markets.

Foreign investors have also the possibility to access emerging markets via instruments such as Eurobonds, Country Funds, and American Depository Receipt and their varieties (Global, International, and European Depository Receipts).11 These instruments are very useful in case where the emerging market under consideration is technically closed to foreign participation. Their prevailing advantage is that they permit the holders to mimic the performance of emerging markets without having to deal with investment restrictions or any market imperfections.

1.5.4 The Future of Emerging Market Investments

The analysis of emerging market external financing in Sect. 1.3.1 shows that emerging markets have generally gained a particular attention from foreign investor community in the past. The exceptions comprise the years of 1998, 1999, 2001 and 2002 where emerging markets received much less capital inflows due to the severe impacts of the Asian crisis, the Argentinean debt default and the explosion of internet bubbles. The future of emerging market investments depend upon on some new development trends, as follows:

First, with a contribution of nearly 32% of the world economic output in 2007 and a growth rate which is often two times higher than that in developed economies, the group of 34 emerging market countries could expect a greater share to overall world GDP in the years to come despite the actual global economic slowdown (Table 1.7). The 34 emerging markets comprised 32.18% of the world market capitalization, approximately equal to the share of the North American region in the world market capitalization (33.96%). These observations provide the most appealing argument for allocating to emerging markets.
Table 1.7

Selected economic and indicators of emerging markets in 2007

 

GDP

Stock market cap.

Debt securities

Value

% of GDP

Public

Private

Total

% of GDP

World

54,840.9

65,105.6

119%

28,629.3

51,585.8

200,162.8

365%

European Union

15,741.1

14,730.9

94%

8,778.3

19,432.3

58,683.5

373%

North America

15,243.6

22,108.8

145%

7,419.2

24,491.9

69,265.0

454%

Emerging market

17,270.8

20,950.2

121%

5,001.3

2,795.6

46,019.1

266%

Asia

7,680.4

13,782.7

179%

2,645.8

1,826.9

25,937.6

338%

Latin America

3,641.0

2,292.2

63%

1,456.5

628.6

8,018.9

220%

Middle East

1,557.8

1,275.9

82%

39.5

84.3

2,958.3

190%

Africa

1,101.7

1,181.7

107%

89.0

78.9

2,452.4

223%

Europe

3,289.9

2,417.6

73%

770.4

176.9

6,655.5

202%

Notes: Data are from Standard and Poor’s Emerging Market Database (IMF World Economic Outlook, April 2009). The sample of emerging markets includes 34 markets of five regions. All values are expressed in billions of US dollars. GDP is calculated on the basis of purchasing power parity

The second point to be noticed is that emerging markets regained investor’s confidence and market credibility for emerging markets since 2002. The total issuance amount of equity, bonds and syndicated loans increased considerably from $135.60 billion in 2002 to $446.54 billion in 2008 with a record peak of $726.40 billion in 2007. The recent rise of macroeconomic and financial uncertainties due to the recession of world economy sparked by the US housing and banking crisis might lead to shrinking capital flows to emerging markets, but private investment flows should increase insofar as the recovery of most advanced economies comes.

Next, the economic reality proves that emerging market countries are not neither decoupled from the developed part of the world nor spared from the global crisis. Although they are not directly affected by the global crisis, most of emerging countries in Asia and Latin America have experienced sharp decline in their exports of finished products and commodities. The fast-growing emerging countries in Europe had to turn to the IMF and the European Union for financial assistance in order to overcome rising sovereign risks, social instability, bank liquidity problems and the likelihood of currency devaluations. Consequently, growth projections for almost all emerging countries have been recently reduced. They may, however, have a greater room for manoeuvre than developed countries in the conduct of stimulus plans to foster economic growth due to their higher reserve levels as well as lower debt levels.

Finally, the equity market valuation measures, as indicated in Fig. 1.7, show that both the price/earnings and price-to-book ratios have experienced an upward trend while the dividend-yield ratios have decreased substantially since 2005. Taking together, these trends give evidence of equity price overvaluation over the period of 2005–2007 in emerging stock markets, which was partially corrected by the sharp decline during the current global financial crisis starting in July 2007. Expectedly, equity investment flows to emerging markets should recover when the overvaluation risk entirely disappears by the end of 2009 according to market valuation forecast figures.
Fig. 1.7

Equity market valuation measures: 2003–2007. Notes: Data are from Standard and Poor’s Emerging Market Database (IMF World Economic Outlook, April 2009). The sample of emerging markets includes 34 markets of five regions

To conclude, the arrival of capital inflows depends on a rigorous monitoring of the banking and financial system as well as on sound macroeconomic policies of emerging market economies. Additionally, the investor’s capital investment decision-making relies closely on the actual degree of financial liberalization.

1.6 Summary

This chapter presented the evolutionary characteristics of emerging financial markets with a particular focus on equity markets. It appears that these markets are very heterogeneous and exhibit numerous disparities in terms of market size, liquidity, financial depth, and development levels. With regard to their risk-return characteristics, the most important finding is that emerging markets have now positive and moderate with developed markets, indicating a higher degree of market comovement in the recent period. However this increased correlation does not lead to eliminate international diversification benefits as emerging markets still outperform largely over the long-run thanks to their reduced volatility. Finally, it should be noted that the existence of investment barriers and the importance of country-specific risks may limit foreign participation even though they have considerably diminished over time.

Footnotes

  1. 1.

    By the end of 2008, national economies are divided into three groups: low income countries (also referred to as less developed countries) with GNI per capital of $975 or less, low and middle income countries with GNI per capita ranging from $976 to $11,905, and high income countries with GNI per capita of $11,906 or more. Within the low and middle income class, all countries with GNI per capital higher than $3,855 are typically included in an upper middle income category.

  2. 2.

    The IFC is a member of the World Bank group in charge of promoting sustainable economic growth in developing countries through financing private sector investments, mobilizing capital in the international financial markets, and providing advisory services to businesses and governments.

  3. 3.

    Interested readers can refer to the S&P’s Emerging Markets Index Methodology (November, 2007) for more detailed information about country inclusion criteria.

  4. 4.

    A foreign bond is a bond issued by a non-resident entity in a domestic market, denominated in the currency of the country where it is issued and only negotiated in a predetermined exchange. Eurobonds refer to bonds denominated in a currency different from the currency of the country or market where they are issued. A Eurodollar bond (i.e., US dollar-denominated) issued by a Thai company in Japan is an example of Eurobonds. In practice, Eurobonds are often denominated in the currency of one of the most advanced countries such as US dollar, Japanese Yen, Euros and UK Pound Sterling, and their issue is led by an international underwriting syndicate of international banks, brokers and dealers. Note that they are more attractive than foreign bonds because the issuers have the flexibility to choose the country in which the bonds are issued as well as to denominate the bonds in their preferred currency. In addition, there is no fix physical market place for Eurobonds, but they can be traded globally and listed in one of the Eurocenters developed throughout the world (New York, London, Paris, Tokyo, etc.).

  5. 5.

    Data on market indicators are obtained from S&P’s Global Stock Market Factbook (2004) and Emerging Market Database. The years of 1990 and 2003 are intentionally chosen for comparative purpose because they cover the period of intensive market openings in almost all emerging countries.

  6. 6.

    Throughout this book we use interchangeably the following expressions: financial liberalization, stock market liberalization and market liberalization.

  7. 7.

    Note that the estimation of Adler and Dumas’s (1983) model is only possible for a very small number of countries.

  8. 8.

    Traditional methods for political risk assessment include, among others, the comparative techniques of risk rating and mapping systems, and the analytical techniques of special reports, expert systems and country default probability determination (Clark and Tunaru 2001).

  9. 9.

    MSCI EAFE is a market-capitalization-weighted index constructed from the perspective of North American investors. Its constituents include listed stocks from 21 developed countries in Europe, Australasia, and Far East (e.g., Australia, Austria, Finland, Singapore, Sweden, UK, etc.) excluding the US and Canada. The regional weights as of December 31, 2006 are approximately as follows: 45.27% for Europe (excluding the UK), 23.71% for the UK, 25.55% for Japan, and 8.47% for Asia Pacific.

  10. 10.

    The increase in cross-market correlations reflects the fact that emerging markets commove largely with developed in recent years. Three main factors explain this phenomenon: the financial interdependences due to high degree of cross-border capital mobility, the economic integration resulting from tighter trade links and increased number of companies with international operations, and the rapid convergence of emerging markets toward the economic and financial structure of mature markets.

  11. 11.

    Eurobonds are simply international bonds that are denominated in a currency other than the currency of the country or the market in which they are issued. They are sold throughout the world. Country fund refers to an investment company that issues a number of shares in its home market and uses the proceeds to invest in a portfolio of assets in a foreign country. American Depository Receipt is a negotiable certificate issued by a US bank that represents a certain amount of shares of a foreign company in a foreign stock market. The financial characteristics of these instruments are discussed in Chap.  2.

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Copyright information

© Springer-Verlag Berlin Heidelberg 2010

Authors and Affiliations

  • Mohamed El Hedi Arouri
    • 1
  • Fredj Jawadi
    • 2
  • Duc Khuong Nguyen
    • 3
  1. 1.Faculty of Law, Economics, and ManagementUniversity of OrleansOrléansFrance
  2. 2.Amiens School of ManagementAmiensFrance
  3. 3.ISC Paris School of ManagementParisFrance

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