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Asset pricing in emerging markets
Robert T 08-23-2006, 5:20 PM | Post #2231261 | 
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I've got a bit behind on this thread - apologies for the slow response. Increased family and work commitments are keeping me busy.

These are the key messages I took away from the Harvey article.

1. Cost of capital in emerging markets declines with market integration reflecting the lowering of risk of the lender (investor) from a country portfolio variance to covariance with global returns. The result can be a lower expected return with the same asset volatility. Its not the characteristics of the individual asset class that matter, its how it affects the characteristics of an overall portfolio.

2. While many emerging markets have 'liberalized', thus opening the scope for greater market integration, this many be more on paper than in fact. i.e. there a lack of credibility of reforms with a threat of future policy reversals etc. so foreign investors don't enter the market, or enter slowly. In addition, risks are still high - information asymmetries, inhibiting or poorly enforced regulations, illiquidity etc.

3. Emerging market equities have high negative skewness (higher than 'normal' downside losses). Which when added to a portfolio can contribute to the negative skewness of an overall portfolio.

What do these messages seems to imply? (at least to me)

1. International investors probably didn't benefit much from the high return of segemented emerging markets by the mere fact than these were essentially closed economies with no (or little) opportunities to invest.

2. The emerging markets we can invest it - by definition are more integrated but the cost of capital will likely be higher than in developed markets due to remaining risks (as above). If these risks were significantly reduced or eliminated then costs of capital would likely equal those of a developed country, and the country at that time would probably have already graduated to developed country status.

What impact does this have on portfolio choice? (at least ours)

1. Emerging market equities still have a higher expected return than developed market equities, although lower than pre-market integration (which was irrelevant to international investors anyway?). Volatility may not decline from pre-market integration levels but this may add positive co-variance attributes to a portfolio, and hence diversification benefits.

2. Including US treasuries as part of fixed income can offset some of the negative skewness that emerging markets add to a portfolio i.e. in financial crisis/flight to quality episodes emerging market equities do badly while US treasuring typically to well.

Out of curiosity I redid the portfolio simulations in # 55 using 1995-2005. The annualized return:SD results were: 12.0:12.4 with EM; and 11.8:12.4 without EM. A smaller but still positive impact.

Interesting article BTW.

Robert

Originally posted in thread: 52623
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