Yale School of Management 1 Emerging Financial Markets Lecture 2: Market Overview Topics for today: Trading and return characteristics Ownership limits for foreign investors Accounting issues Liquidity issues and trading costs Short-sale constraints

Yale School of Management 2 3 The IFC Definition: Income less than $9,000 20% GDP, 80% Population, 72% Area, And 16% Market Capitalization in the World (2003) Higher growth rates & high avg returns in many countries Time Taken to Double Per capita Output (10 years but unstable) What is an Emerging Market?

Yale School of Management 3 The Emerging Markets Integration Index = Country’s share in world Invesment stocks Country’s share in World GDP Share of world GDP (in ppp, 1990 international dollars) Share of international investment stocks in 1913 and 2000 Integration Index

Yale School of Management 4 Financial Markets also emerge, submerge and re-emerge Argentina’s stock market:  Founded in 1872  Submerged in 1965  Re-emerged in 1975 Peru: , 57-77, 88-

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

Yale School of Management 7 Major Emerging Equity Markets Note: MKT-market Value, Tvol-Trading Volume, Nlist-Number of listed companies

Yale School of Management 8 6 Various Forms of Capital Controls Foreign ownership limits are often imposed in EM. Different class of shares and their pricing: shares for foreign investors may sell at a discount or premium to domestic shares.

Yale School of Management 9 Eun & Jarakiramannan (1986)

Yale School of Management Number of expropriations of foreign assets in different countries: development leading to new globalization 10 DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC policy, ”, Journal of International Business Studies, 1994, pp

Yale School of Management Number of countries expropriating foreign assets 11 DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC policy, ”, Journal of International Business Studies, 1994, pp

Yale School of Management 12 Harvey & Roper (1999)

Yale School of Management 13 Harvey & Roper (1999)

Yale School of Management 14 Harvey & Roper (1999)

Yale School of Management 15 Example: Mexico (Domowitz, Glen and Madhavan (1997)

Yale School of Management 16 Mexico: for financial firms

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Yale School of Management 18 6 One Stock, Two Prices

Yale School of Management 19 Accounting issues Poor financial accounting: hard to value assets Are accountings numbers useless? 9

Yale School of Management 20 How do you handle cross-holding of shares?

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Yale School of Management 22 2 Measuring Emerging Market Returns Local currency returns vs. dollar returns Arithmetic, geometric, and internal rates of return Geometric means are always smaller or equal to arithmetic means. If one compounds geometric mean returns, one will always get the actual return during the sample period. One should use geometric returns in emerging markets due to high volatility.

Yale School of Management 23 Emerging Market Return Distribution High Serial Correlations in Short-run. (Basis for Momentum strategies) Long-term Mean Reversion for many EMs. (Basis for Value strategies) Excess Skewness and Kurtosis (Fat Tails, high probability for large surprises) Conventional Derivatives Pricing Tends to Under-price in Emerging Markets Due to Excess Kurtosis.

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Yale School of Management 29 Crises tend to occur often in EM

Yale School of Management 30 Speculations in EM lead to more frequent crises

Yale School of Management 31 PE and Dividend Yield in Taiwan

Yale School of Management 32 The Nature of Market Return Volatility International Volatility Comparison: EM Could Be 10 Times More Volatile. Correlation of Market Volatilities (The “Asian flu”: market volatilities tend to increase at the same time.) A Simple Model of Average Volatility:positively Related to GDP Growth, Negatively Related to IICCR. Systematic Risk: Positively Related to GDP Growth. 3

Yale School of Management 33 Time-varying Volatility: Indonesia as an example (S.D. of Monthly Dollar Returns)

Yale School of Management 34 Volatility Contagion (S.D. of Monthly Dollar Returns)

Yale School of Management 35 Very Weak Relationship Between Beta (EM & world) and Mean Returns (volatilities do better): caution on CAPM 7

Yale School of Management 36 Trading and Liquidity Issues in EM High transaction costs: over 5% for a round trip. Many trades may fail to settle. Illiquidity: cannot sell your position without taking substantial price cut. Front-running: you may be ripped off. 7

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Yale School of Management 39 Other Trading Costs? (Plexus Group’s findings for U.S.)

Yale School of Management 40 In addition to liquidity issues, Short-sales may not be allowed in EMs