Emerging Financial Markets 2: Measuring Market Return And Volatility Prof. J.P. Mei

Major Emerging Equity Markets Note: MKT-market Value, Tvol-Trading Volume, Nlist-Number of listed companies

6 Various Forms of Capital Controls u u Various foreign exchange controls are often imposed in EM. u u Different class of shares and their pricing: shares for foreign investors may sell at a discount or premium to domestic shares. (E.G., A & B shares in China, TSMC) u u These may be investment opportunities but not arbitrage opportunities.

6 One Stock, Two Prices

Investor’s Nightmare? u u Lack of transparency and information disclosure: inside dealing u u When an Event is not an Event: Measurement of inside dealing u u Front-running: you may be ripped off. u u High transaction costs: over 5% for a round trip. u u Many trades may fail to settle. u u Market illiquidity: can not sell your position without taking substantial price cut. 7

Accounting issues u u Poor financial accounting: hard to value assets (How do you value a machine that has never been used?) u u Are accountings numbers useless? u u How to become rich using GAAP? 9

2 Measuring Emerging Market Returns u u Local currency returns vs. dollar returns u u Arithmetic, geometric, and internal rates of return (used for investment projects) u u Geometric means are always smaller or equal to arithmetic means. u u If one compound geometric mean returns, one will always get the actual return during the sample period. u u One should use geometric returns in emerging markets due to high volatility.

Emerging Market Return Distribution u u Generally High Serial Correlations in Short- run. (Basis for Momentum strategies) u u The Presence of Long-term Mean Reversion for many EMs. (Basis for Value strategies) u u The Presence of Excess Skewness and Kurtosis (Fat Tails, high probability for large surprises) u u Conventional Derivatives Pricing Tends to Under-price in Emerging Markets Due to Excess Kurtosis.

The Nature of Market Volatility u u International Volatility Comparison: EM Could Be 10 Times More Volatile. u u High Variation in Mean and Standard Deviation of Returns. u u Correlation of Market Volatilities (The “Asian flu”: market volatilities tend to increase at the same time.) u u A Simple Model of Average Volatility:positively Related to GDP Growth, Negatively Related to IICCR. u u Systematic Risk: Positively Related to GDP Growth. u u Very Weak Relationship Between Beta (EM & world) and Mean Returns (volatilities do better) 3

Time-varying Volatility (S.D. of Monthly Dollar Returns)

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

Very Weak Relationship Between Beta (EM & world) and Mean Returns (volatilities do better) 7

The volatility of market valuation

The volatility of Interest rates

Lynch Ratio Sample of 45 comparable firms, 1998

Alternative Measurement of Emerging Market Risk:IICCR u u Selective Country Ratings for EM Countries: They Are Highly Correlated. u u What Determine Country Credit Ratings: CPI, GDP Per Capita, Market Cap, Growth. u u Country Ratings Affect GDP Growth and Equity Returns. (Application: Cost of Capital Estimation in Project Finance) u u Analysis of EM return, risk, and other factors: 9

The Relationship between Rule of Law vs. IICCR

Impact of Speculation on Market Volatility u u Tulip Bulbs and the 1980s Speculative Craze in Taiwan u u Rocket Rise in Equity Market Prices u u Frenzied Market Turnover u u Little Attention on the Real Economy u u Valuation Levels, Such P/E Ratios and Dividend Yields, Can Help Spotting Speculative Craze

PE and Dividend Yield at Historical Levels