From Reading #74 in Schweser V5 (p134): “Political risk declines with liberalization. Lower political risk results in higher stock returns because political risk is priced by investors. With higher stock returns comes a reduced cost of capital for the developing country firms…” I don’t see how lower political risk results in higher stock returns. I would say lower political risk should lead to lower stock returns (at least in the long run). Overall, what are short term and long term effects of liberalization on stock returns?
lower political risk means that more money will flow into the market, driving prices up and thus increasing the returns when there is political instability in a given country capital will flee, prices will drop, and returns will be lower
But once prices have increased, returns should stabilize, no?
yes, returns would drop and stabilize as the market is integrated. But, note that liberalization does not automatically lead to market integration. I know in Schweser that capital flows are more volatile in developed markets than EM. does anyone know why this is the case?
I think key points from liberalization 1) Increased capital flows 2) Slightly lower dividend yield 3) Slightly higher correlation 4) Higher returns due to covariance < variance (when market became integrated, only world risk is priced), 5) returns level after 5 years 6) Liberazation benefits accrue mostly to top quartile of population 7) Developed market flows are still more volatile then emergine markets flow To answer the question why capital flows are more volatile - it is because capital can move more freely then in EM
Comp_sci_kid, Schweser disagrees with your #4: p132 of V5: The expected return for the newly liberalized market should decline due to its covariance being less than its variance. My interpretation: once market became integrated, you’re being priced for your risk (i.e. covariance with other markets). Hence, lower risk -> lower return.
tanyusha AFTER market become integrated, initially integration will cause prices to rise, expected return will decline long run as you wont get compensated for bearing country specific risk
you also have to remember liberaziation != integration
Then what is your interpretation of Schweser statement? They’re talking about newly liberalized (not integrated!) market? I guess I would interpret “expected return” as return in the future i.e. not immediate return (immediate return is in fact higher).