Emerging Financial Markets 2: Measuring Market Return And Volatility

Prof. J.P. Mei

Major Emerging Equity Markets

Rank MKt MCP Rank Mkt TVol Rank Mkt Nlist

1 US 11.3 1 US 10.2 1 US 8851

10 HK 0.41 2 TW 1.2 2 IN 5843

13 TW 0.28 7 HK 0.48 7 SL 872

15 BR 0.25 10 CH 0.37 8 PK 781

16 SA 0.23 14 BR 0.20 9 KO 776

Note: MKT-market Value, Tvol-Trading Volume, Nlist-Number of listed companies

6

Various Forms of Capital Controls Various foreign exchange controls 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.

(E.G., A & B shares in China, TSMC)

These may be investment opportunities but

not arbitrage opportunities.

6

One Stock, Two PricesFROM 1-1-99 TO 1-17-01 WEEKLY INDEXED

J F M A M J J A S O N D J F M A M J J A S O N D J50

100

150

200

250

300

350

400

450

500

550

600

TAIWAN SEMICON.SPN.ADR 1 ADR = 5 SHARESTAIWAN SEMICON.MNFG.

HIGH 580.42 2-4-00 LOW 100.00 1-1-99 LAST 248.34HIGH 379.39 2-11-00 LOW 100.00 1-1-99 LAST 208.44Source: DATASTREAM

Investor’s Nightmare? Lack of transparency and information

disclosure: inside dealing When an Event is not an Event:

Measurement of inside dealing Front-running: you may be ripped off. High transaction costs: over 5% for a round

trip. Many trades may fail to settle. Market illiquidity: can not sell your position

without taking substantial price cut. 7

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.

Average Number of Days Taken to Collect Dividend, 1995(Source: Global Securities Consulting Services, Ltd.)

34.2

16.214.8

6.55.3

4.5

2.5 2.11 0.7

0

5

10

15

20

25

30

35

40

Philippines India Venezuela Argentina Brazil Thailand Korea UK UnitedStates

Germany

GSCS Settlement Benchmark(As of end 1996, Source: Global Securities Consulting Service, Inc)

95.291

86.1 85.8

75.6

52.3

1.3 0.7

-10

0

10

20

30

40

50

60

70

80

90

100

110

Turkey Brazil Malaysia Mexico Philippines Indonesia South Africa India

Accounting issues Poor financial accounting: hard to

value assets

(How do you value a machine that

has never been used?)

Are accountings numbers useless?

How to become rich using GAAP?

9

Table 1: Original Balance Sheets

Company A Company BCash: 100 Cash: 100Real Asset: 100 Equity: 200 Real Asset: 100 Equity: 200Shares Outstanding :200 Shares Outstanding :200Book Value per share: 1.00 Book Value per share: 1.00

Table 2: Balance Sheet when A Buys 100 of B's stock

Company A Company BCash: 0 Cash: 200Real Asset: 100 Equity: 200 Real Asset: 100 Equity: 300Investment: 100Shares Outstanding :200 Shares Outstanding :300Book Value per share: 1.00 Book Value per share: 1.00

Table 3: Balance Sheet with 200 in Total Cross Holdings

Company A Company BCash: 100 Cash: 100Real Asset: 100 Equity: 300 Real Asset: 100 Equity: 300Investment: 100 Investment: 100Shares Outstanding: 300 Shares Outstanding: 300Book Value per share: 1.00 Book Value per share: 1.00

Table 4: Balance Sheet with 3600 in Total Cross Holdings

Company A Company BCash: 100 Cash: 100Real Asset: 100 Equity: 2000 Real Asset: 100 Equity: 2000Investment: 1800 Investment: 1800Shares Outstanding: 2000 Shares Outstanding: 2000Book Value per share: 1.00 Book Value per share: 1.00

2

Measuring Emerging Market Returns Local currency returns vs. dollar returns Arithmetic, geometric, and internal rates of

return (used for investment projects) Geometric means are always smaller or

equal to arithmetic means. If one compound 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.

Emerging Market Return Distribution Generally High Serial Correlations in Short-

run. (Basis for Momentum strategies)

The Presence of Long-term Mean Reversion for many EMs. (Basis for Value strategies)

The Presence of 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.

Average Dollar Return and Volatility of Selected Markets, 1977-1998

Country

Average

Annual

Return

(%)

No. of Years

In Which

Returns Were

Positive

No. of Years

in Which

Returns Were

Negative

Highest

Yearly

Return

(%)

Lowest

Yearly

Return

(%)

Volatility

Index

(U.S.=100)

Argentina 13.1% 12 10 395.6% -61.9% 827

Brazil 4.1 11 10 150.2 -64.2 822

Chile 20.2 15 6 148.2 -56.9 609

Greece 4.7 11 9 141.6 -57.3 570

Hong Kong 19.7 15 7 119.9 -40.3 681

India 8.8 13 8 104.0 -34.2 402

Thailand 5.0 11 9 108.9 -78.4 471

United States 15.7 18 3 37.2 -4.6 100

Data Source: International Finance Corporation.

Summary Statistics-April 1991 - March 1996

Country Start DateArithemetic

ReturnGeometric

ReturnStandarddeviation Skewness Kurtosis

NomalityTest

P-value

FirstOrder

Autocorrel

BetaMSCIWorld

BetaMSCI

AC World

BetaIFCG

CompositeArgentina Apr-91 35.5% 25.6% 56.7% 3.09 16.92 0.00 0.06 1.53 1.69 0.91Brazil Apr-91 44.3% 37.1% 52.2% 0.89 1.51 0.00 0.09 1.19 1.43 1.38Chile Apr-91 24.7% 23.6% 26.6% 0.35 -0.43 0.04 0.23 0.09 0.20 0.64Colombia Apr-91 40.5% 39.0% 40.1% 1.33 2.02 0.00 0.54 -0.05 -0.01 0.25Greece Apr-91 -2.7% -5.5% 24.1% -0.34 0.06 0.32 0.16 0.52 0.54 0.28India Apr-91 12.6% 6.3% 36.8% 0.67 1.47 0.20 0.25 -0.60 -0.49 0.69Indonesia Apr-91 9.5% 5.5% 29.2% 0.15 0.09 0.83 0.18 0.58 0.72 1.04Jordan Apr-91 10.0% 9.4% 14.3% 0.34 -0.80 0.00 0.07 0.11 0.13 0.11Malaysia Apr-91 20.4% 19.1% 23.9% -0.06 1.03 0.26 -0.16 0.57 0.67 0.87Mexico Apr-91 15.7% 8.5% 37.5% -1.01 2.04 0.09 0.33 0.83 1.08 1.40Nigeria Apr-91 37.5% 12.7% 69.5% 1.19 11.92 0.00 -0.04 1.15 1.14 -0.05Pakistan Apr-91 22.4% 18.1% 35.3% 1.03 1.92 0.01 0.30 0.06 0.15 0.57Philippines Apr-91 24.1% 22.4% 28.7% 1.37 4.47 0.18 0.02 0.54 0.69 1.10Portugal Apr-91 8.3% 6.6% 19.6% 0.41 1.55 0.29 0.01 0.98 1.01 0.25S. Korea Apr-91 7.8% 4.7% 26.0% 1.07 1.75 0.03 0.04 0.41 0.51 0.68Taiwan Apr-91 7.3% 1.4% 37.1% 2.24 7.65 0.00 0.08 0.69 0.88 1.42Thailand Apr-91 20.1% 17.2% 30.0% 1.08 1.85 0.03 0.03 0.20 0.35 1.14Turkey Apr-91 13.6% -3.9% 61.2% 0.64 0.42 0.04 0.08 -0.12 -0.01 0.87Venezuela Apr-91 -7.0% -16.8% 45.8% -0.45 1.91 0.24 -0.25 0.45 0.54 0.57Zimbabwe Apr-91 4.8% -1.1% 34.9% 0.38 0.87 0.37 0.32 0.84 0.90 0.55MSCI World Apr-91 11.2% 11.1% 10.7% -0.32 -0.34 0.08 -0.25 1.00 1.01 0.20MSCI AC W’d Apr-91 11.0% 11.0% 10.5% -0.23 -0.39 0.14 -0.22 0.98 1.00 0.25IFCG Comp. Apr-91 11.4% 10.6% 16.4% 0.93 3.47 0.08 0.40 0.47 0.62 1.00*Composite: IFC Global Composite; AC World: MSCI All Country Index. Source: IFC Global Indices, MSCI Indices. Monthly returns in US Dollars.Source: Erb, Harvey and Viskanta

The Nature of Market Volatility

International Volatility Comparison: EM Could Be 10 Times More Volatile.

High Variation in Mean and Standard Deviation of Returns.

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. Very Weak Relationship Between Beta (EM & world)

and Mean Returns (volatilities do better) 3

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

Indonesia

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

94 95 96 97

Vo

lati

lity

Indonesia

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

9495

96

97

Indonesia

Korea

Brazil

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Indonesia

Korea

Brazil

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

7

Regression Of Returns On Country Variables

Var Coef t-Stat

Constant 0.009 0.068

Freedom

Index

0.004 0.106

GDP

Growth(%)

0.008 1.180

Rule of Law 0.026 2.240

IICCR -0.003 -1.507

EM Beta 0.016 0.431

World Beta 0.025 0.614

Volatility 0.718 1.868

R2(adjusted) 0.157

The volatility of market valuation FROM 1-4-88 TO 3-31-99 MONTHLY

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 19990

5

10

15

20

25

MEXICO-DS MARKET - DIVIDEND YIELDMEXICO-DS MARKET - PER

Source: DATASTREAM

The volatility of Interest rates FROM 1-4-94 TO 3-31-99 WEEKLY

1994 1995 1996 1997 1998 199910

20

30

40

50

60

70

80

90

100

MEXICO CETES 28 DAY CLOSING - MIDDLE RATEMEXICO CETES 2ND MKT. 360 DAY - MIDDLE RATE

Source: DATASTREAM

Lynch Ratio Sample of 45 comparable firms, 1998

0

5

10

15

20

25

30

Growth (%) P/E

0

0.2

0.4

0.6

0.8

1

Growth-to-P/E

Alternative Measurement of Emerging Market Risk:IICCR

Selective Country Ratings for EM Countries: They Are Highly Correlated.

What Determine Country Credit Ratings: CPI, GDP Per Capita, Market Cap, Growth.

Country Ratings Affect GDP Growth and Equity Returns. (Application: Cost of Capital Estimation in Project Finance)

Analysis of EM return, risk, and other factors:

9

bXay

The Relationship between Rule of Law vs. IICCR

0

20

40

60

80

100

0 2 4 6 8 10 12

Rule of law

IICC

R

Impact of Speculation on Market Volatility

Tulip Bulbs and the 1980s Speculative Craze

in Taiwan

Rocket Rise in Equity Market Prices

Frenzied Market Turnover

Little Attention on the Real Economy

Valuation Levels, Such P/E Ratios and

Dividend Yields, Can Help Spotting

Speculative Craze

TAIWAN SE WEIGHTED - PRICE INDEXFROM 1-1-87 TO 1-22-01 MONTHLY

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

000'S

0

2

4

6

8

10

12

14

Source: DATASTREAM

FROM 1-4-88 TO 3-31-99 MONTHLY

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 19990

10

20

30

40

50

60

70

80

90

TAIWAN-DS MARKET - DIVIDEND YIELDTAIWAN-DS MARKET - PER

HIGH 2.31 10-4-90 LOW 0.42 9-2-88 LAST 1.59HIGH 87.5 9-2-88 LOW 16.0 10-4-90 LAST 19.6 Source: DATASTREAM

PE and Dividend Yield at Historical Levels