Emerging Markets Finance Quiz

Jean Daniel is an emerging markets portfolio manager for a large private investment group, Lakefront Financial, based in the U.S. Laura Shrum is a junior analyst at the firm, whose responsibilities include measuring the benefits of incorporating emerging markets into a portfolio based on long-term perspectives. During a weekly firm meeting on past performance and potential changes in future firm strategy, Daniel and Shrum provide some historical perspective on the performance of emerging market equities, using data from 1980 to 2005. Before discussing the specifics of the data, Daniel states that it is important to understand the process of economic and financial liberalization because emerging countries are increasingly using liberalization to increase foreign investment in their country which aids in the development and growth of the economy. She states that a country’s financial markets will remain segmented unless it undergoes liberalization first because foreign investors will otherwise refuse to invest in the country’s assets. Shrum states that investors are sometimes biased toward their home markets and are heavily weighted in their home country assets. This occurs, Shrum says, for various reasons including the fact that investors are often more comfortable with investments they are familiar with. Shrum says that market integration and the home country bias are related because the home country bias will prevent markets from becoming more integrated. Providing a summary of the data, Daniel states that the risks of investing in emerging markets can be quite high. She states that the best way to measure the risk of large losses in emerging markets is to use the variance-covariance or analytical value-at-risk (VAR) measure. She states that this measures the left-tail risk that most investors are concerned with. Shrum adds that when an emerging country undergoes economic and financial liberalization, the historical data for emerging markets will contain structural breaks, which she states will make the data less useful for predictive purposes. Discussing the risk of emerging markets in more detail, Daniel states that contagion is a particular risk in emerging countries. Contagion, she states, is evidenced by the higher correlations in emerging market stock returns during periods of crisis. In regards to the effects of liberalization on stock return risk, Shrum states that when investment restrictions are lifted after liberalization, foreign investors will be able to pull their money in and out easier. This she states, will increase speculative capital flows and the variability of stock returns will increase in the short-term after liberalization. In addition to the changes in emerging markets already discussed, Daniel and Shrum state that other changes will occur as well. To test the new employees of Lakefront Financial, they provide the following table of data for hypothetical emerging markets. They then ask the employees to identify the newly liberalized emerging market, based solely on the change in the data for each country before and after the supposed liberalization. Cost of Capital Exports in $ Dollars Inflation Government Debt Before After Before After Before After Before After A 24.20% 21.50% $882 $779 9.10% 13.50% 39% 35% B 23.40% 21.20% $595 $888 8.60% 8.00% 33% 25% C 25.80% 28.90% $993 $818 9.20% 7.50% 42% 45% Later in the day, Daniel and Shrum discuss the risk of investing in individual stocks in emerging markets. Daniel states that corporate governance can be a particular problem in emerging markets and that the enforcement of shareholder rights has been traditionally weak. She states that during emerging market crises, companies with weak corporate governance tend to suffer losses. Shrum adds that the effectiveness of a corporation’s governance can be increased by increased analyst coverage, especially when the firm is controlled by family members. Daniel and Shrum have made an investment in the emerging country of Walenzia. Fortunately, they have found a bank that will write an over the counter options contract for the Walenzian currency, abbreviated as WP. Lakefront Financial’s position in Walenzian stocks is valued at WP 10,000,000. The option delta is 0.3 and the number of WP in one option contract is SF 31,250. Regarding their statements concerning emerging market liberalization and integration? Daniel Shrum A) Correct Correct B) Incorrect Correct C) Correct Incorrect -------------------------------------------------------------------------------- Regarding their statements concerning the value-at-risk measure and structural breaks? Daniel Shrum A) Incorrect Correct B) Correct Correct C) Correct Incorrect -------------------------------------------------------------------------------- Regarding their statements concerning contagion and post-liberalization stock return variability in emerging countries? Daniel Shrum A) Correct Correct B) Incorrect Incorrect C) Correct Incorrect -------------------------------------------------------------------------------- Which of the following countries from Daniel and Shrum’s table is most likely the newly liberalized emerging market, based solely on the change in the data for each country before and after the supposed liberalization? A) Country B. B) Country A. C) Country C. -------------------------------------------------------------------------------- Regarding their statements concerning corporate governance in emerging countries? Daniel Shrum A) Correct Correct B) Incorrect Incorrect C) Correct Incorrect -------------------------------------------------------------------------------- How should Lakefront Financial hedge the currency risk of the Walenzian stock position? A) Buy 320 WP call contracts. B) Buy 320 WP put contracts. C) Buy 1,067 WP put contracts.

1)B 2)A 3)A 4)B 5)A 6)C

egarding their statements concerning emerging market liberalization and integration? Daniel Shrum A) Correct Correct B) Incorrect Correct C) Correct Incorrect Your answer: A was incorrect. The correct answer was B) Incorrect Correct Daniel is incorrect. Although liberalization is important and increasingly used, a country’s financial markets need not remain completely segmented before it undergoes liberalization. In other words, there are degrees of integration that may be accomplished by means other than liberalization. For example, a market can be accessible through American Depository Receipts (ADRs) or through closed end country mutual funds before the government begins the liberalization process. In this case, the market is partially integrated. Shrum is correct. Investors may shun emerging markets because they have a home country bias, where they invest a disproportionate amount in their home market and less in foreign markets. This will prevent markets from becoming more integrated because capital will not flow freely between borders. The home country bias occurs for various reasons including investors’ behavioral preference for familiar stocks. (Study Session 12, LOS 36.b) -------------------------------------------------------------------------------- Regarding their statements concerning the value-at-risk measure and structural breaks? Daniel Shrum A) Incorrect Correct B) Correct Correct C) Correct Incorrect Your answer: A was correct! Daniel is incorrect. Although VAR measures left-tail risk, the analytical method (also known as the variance-covariance or delta normal method) for estimating VAR requires the assumption of a normal distribution. This is because the analytical method utilizes the standard deviation of returns. For example, in calculating a daily VAR we calculate the standard deviation of daily returns in the past and assume it will be applicable to the future. Then using the asset’s expected one-day return and standard deviation, we estimate the one-day VAR at the desired level of significance. The assumption of normality is problematic because it is well documented that returns are not normally distributed in emerging markets. Shrum is correct. Emerging market data often contain structural breaks (e.g., when liberalizations occur, the pattern of stock returns dramatically changes). If a country is expected to undergo a structural change in the future, then historical data are not very useful for prediction. (Study Session 12, LOS 36.c) -------------------------------------------------------------------------------- Regarding their statements concerning contagion and post-liberalization stock return variability in emerging countries? Daniel Shrum A) Correct Correct B) Incorrect Incorrect C) Correct Incorrect Your answer: A was incorrect. The correct answer was B) Incorrect Incorrect Daniel is incorrect. In emerging markets, there is evidence that extreme negative movements in one market coincide with the same in others, which most investors think of as contagion. However, the mere presence of increased correlations between markets during crisis periods does not suffice as evidence of contagion because correlations increase as volatility increases due simply to the statistical properties of the correlation measure. Shrum is incorrect. Although liberalization may positively impact return variability if greater information flow results in increases in speculative capital flows, the empirical evidence demonstrates that liberalization does not affect the volatility of returns. Over the long run after liberalization, return variability should decline as the economy matures. (Study Session 12, LOS 36.c) -------------------------------------------------------------------------------- Which of the following countries from Daniel and Shrum’s table is most likely the newly liberalized emerging market, based solely on the change in the data for each country before and after the supposed liberalization? A) Country B. B) Country A. C) Country C. Your answer: B was incorrect. The correct answer was A) Country B. When an emerging country becomes liberalized, its cost of capital falls, trade and exports increase, and inflation decreases. Additionally, government debt should decrease and economic growth should expand, so government debt to GDP should decline. Country B is the only country of the three that demonstrates these changes after liberalization. (Study Session 12, LOS 36.b) -------------------------------------------------------------------------------- Regarding their statements concerning corporate governance in emerging countries? Daniel Shrum A) Correct Correct B) Incorrect Incorrect C) Correct Incorrect Your answer: A was correct! Daniel is correct. Emerging market firms with weaker corporate governance are more likely to suffer during crises. Shrum is correct. Corporate governance can be improved in emerging countries when analyst coverage increases. This improves firm valuation, especially when the firm is controlled by family and management and when the firm is from a country with poor shareholder rights. In these instances there is greater opportunity for improvement in corporate governance. (Study Session 12, LOS 36.c) -------------------------------------------------------------------------------- How should Lakefront Financial hedge the currency risk of the Walenzian stock position? A) Buy 320 WP call contracts. B) Buy 320 WP put contracts. C) Buy 1,067 WP put contracts. Your answer: C was correct! To hedge the currency risk of the WP stock position, they should buy puts in the amount of WP 10,000,000 × 1/0.3 = WP 33,333,333.33. The put gives them the right to sell WP. With WP 31,250 in one contract, they should buy WP 33,333,333.33/31,250 = 1,067 WP puts. (Study Session 14, LOS 41.a) --------------------------------------------------------------------------------

Contagion, she states, is evidenced by the higher correlations in emerging market stock returns during periods of crisis. ------ If this is incorrect; what exactly is contagion?