Emerging Capital Markets AG907 M.Sc. Investment & Finance M.Sc. International Banking & Finance Lecture 3 – Efficiency & Other Financial Characteristics of Emerging Capital Markets I g n a c i o R e q u e j o – G l a s g o w , 2 0 1 0 / 2 0 1 1
Overview of Lecture 1. Introduction 2. Market Information & Risk-Free Rate 3. Company-Specific Information 4. Evaluating Efficiency 5. Diversification, Return & Volatility Empirical Evidence – Efficiency in African Stock Markets E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 1
1. Introduction Efficient markets ⇒ Security prices reflect all that is known about assets underlying those securities Belief in market efficiency is vital for interpretation of observed prices How much does the market know? • Quality of information available • How the market processes the information E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 2
1. Introduction Studies suggest in DMs quality of both information & processing is reasonably good Do the same conclusions hold for EMs? We need to evaluate • Availability of market wide information • Availability of company-specific information • How such information is processed in EMs E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 3
2. Market Information & Risk-free Rate Difficulty in determining availability of market information & investment horizon Proxy for time span for which timely & reliable information is available ⇒ Term for which local government is able to borrow at fixed-interest rate a) Market in which government is able to borrow in the local currency at fixed rate for 20 years b) Market with only floating-rate debt E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 4
2. Market Information & Risk-free Rate Empirical evidence ⇒ Longest-maturity fixed-rate local- currency-denominated bond issued (period from January 2001 through March 2003) Of 33 EMs, only 17 had any fixed-rate offerings listed Only 14 of this subgroup had quotes for long-rated bond Does absence of fixed-rate market indicate high risk? E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 5
2. Market Information & Risk-free Rate Interpretation ⇒ Absence of borrowing at fixed rate by government that needs financing a) Yields on Colombian & Philippine fixed-rate debt are more than 15% & 13% b) Absence of tradable instruments in Argentina & Brazil Fixed-rate instruments allow investors to estimate risk-free rate of return in local currency ⇒ Baseline return for specific market fundamental to valuation process E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 6
3. Company-Specific Information Apart from general information ⇒ Availability & relevance of company-specific information is important (weak, semi- strong & strong market efficiency) Variance of a firm’s stock price ⇒ Firm-specific vs. market a) If substantial company-specific information available ⇒ Larger amount of total variance due to firm factors b) If not much reliable firm-specific information ⇒ Only reliable information for market as a whole E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 7
3. Company-Specific Information Ranking of EMs according to proportion of stock variance attributable to the overall market (vs. 15% for NYSE) • From a low of about 28% for South Africa • To a high of 74% for Sri Lanka Overall, less relevant firm-specific information available in EMs than DMs Surprises ⇒ Egypt & Jordan / Taiwan E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 8
4. Evaluating Efficiency Availability of market- & company-specific information is not sufficient ⇒ How information is used by the market? Whether and how information is incorporated into prices ⇒ Three levels of market efficiency Weak-form ⇒ past information; no information about • future prices; trends are ruled out; violation in markets with short time horizon investors ⇒ • Semi-strong-form public information; prices incorporate new public information; abnormal returns can be obtained with private information ⇒ • Strong-form all information (public & private); abnormal returns are not possible E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 9
4. Evaluating Efficiency Most DMs exhibit weak & semi-strong form efficiency • Past prices do not predict future prices • Prices adjust quickly to release of new information ⇒ Weak form market efficiency in EMs test basic proposition that stock prices follow random walk (weak- form market efficiency in: Argentina, Brazil, Chile, China, India, Mexico, South Africa & Turkey) Another test ⇒ two-period-lagged autoregressive process to evaluate whether past returns predict current returns E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 10
4. Evaluating Efficiency Further perspective on efficiency in EMs • Trading characteristics (‘Group 1 status’) • Existence of fixed-rate instruments • Relevance of firm-specific information • Evidence on weak-form market efficiency Highest-scoring ⇒ SK, SA, MEX, TAI, SLO, INDO & INDI Lowest-scoring ⇒ MOR, TUR, RUS & PAK E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 11
4. Evaluating Efficiency EMs do not seem to be efficient • 1/2 long-term fixed-rate instrument • Less company-specific information • 1/2 weak-form market efficiency Variation in efficiency among EMs Information on efficiency is relevant to decide valuation method E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 12
5. Diversification, Return & Volatility Two characteristics of EMs attractive for investors • Low correlation with world equity markets • Potential future growth in market cap ⇒ Low correlation reduction of 6% points in total portfolio’s volatility adding EMs securities (Harvey, 1995) Potential growth in market cap of EMs • In 1992 = 9% of world market cap & 19% of world GDP • In 2002 = 10.5% of world market cap & 20% of world GDP E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 13
5. Diversification, Return & Volatility In addition to low correlation EMs / DMs ⇒ Higher returns & volatility in EMs than DMs (Harvey, 1995) Changes in performance characteristics ⇒ Crises in EMs & increased economic & financial integration Four main factors contribute to higher volatility ⇒ • Asset concentration Diversification/concentration intrinsic in indices (vs. country’s industry mix) • Stock market development & economic integration Market microstructure ⇒ Market liquidity & information • asymmetries • Macroeconomic influences & political risk E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 14
5. Diversification, Return & Volatility After Asian crisis (1997) & Russian default (1998) ⇒ Correlation increased between S&P/IFCI Composite Index & S&P 500 & MSCI World indices Contagion ⇒ Spread of financial market turmoil from one country to the next, causing financial markets to move downward in synchronized fashion Financial contagion ⇒ Increases volatility in EMs & correlation with DMs E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 15
5. Diversification, Return & Volatility Factors that can augment the risk of contagion • Weak economic fundamentals • Macroeconomic similarities with other crisis countries • Heavy exposure to certain financial agents • Overall state of international financial markets Technical definitions of contagion • Shock in one country transmitted to another (independent of previous correlation) • How the shock is propagated (through trade, through investor behaviour) ⇒ Only shock above & beyond ‘standard channels’ is contagion E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 16
5. Diversification, Return & Volatility Different types of contagion ‘Pure contagion’ ⇒ idea that financial shocks are • transmitted across markets & countries ‘Shift contagion’ ⇒ if correlation between the two • markets increases during crisis period Benefit of international diversification diminishes if correlation between markets increases significantly during crises E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 17
‘African stock markets: Multiple variance ratio tests of random walks’ Smith, G., Jefferis, K. and Ryoo, H.J. Applied Financial Economics 12 (2002) 475–484 E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 18
Scenario • Increasing prominence of stock markets in EMs one striking feature of international financial development • Most important EMs in Latin America & Asia but recently new stock markets in Africa • Benefits of establishment of stock markets • Attract portfolio investment • Boost domestic savings • Improve pricing & availability of capital for domestic investment E m e r g i n g C a p i t a l M a r k e t s – I g n a c i o R e q u e j o 19
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