Non Normal return distributions Market Efficiency Cost of Capital LOS asks us to “discuss” and I didn’t find anything concrete on these lines in our book. Can someone throw in some points here ? Thanks!
debt dem. in foreign currency.
s23dino - Not sure I understand your point. The LOS asks us to discuss the three issues I highlighted in my post… Thanks!! s23dino Wrote: ------------------------------------------------------- > debt dem. in foreign currency.
ahhh misread your post. for non normal I would say emerging markets have non normal dis due to a higher porportion of large losses rendering standard deviations less useful… something like that?
Emerging markets exhibit non-normal return distributions (Fat Tails, Negative Skewness) and hence standard risk measures that assume normal distributions will understate the risks associated with EM equities/debt. EM’s tend to be Less Efficient than Developed markets therefore mis-pricings tend to occur more frequently and may stay mispriced longer than they would in Developed markets, thus Excess returns can be picked up by exploiting this weakness. The Cost of Capital in EM’s tends to be Higher than the Cost of Capital in Developed Mkts.
Thanks guys! Makes sense… Bigwilly - reason why cost of capital is higher in EM ? I recollect this - during liberalization process, cost of capital reduces due to inflow of foreign capital which induces more firms going IPO. So something opposite ?
but cost of capital is still comparitively higher vis-a-vis developed mkts.
yes dino got the first one. efficiency: the markets are typically semi-efficient. they are not fully efficient because, due to a variety of factors such as insider trading and government run exchanges, there is often information leakage that locals are able to utilize before foreign investors. hence, prices partially reflect the information before it becomes public. the cost of capital declines after market liberalization. capital inflows cause asset prices to increase, thus lowering expected return. they also provide much needed capital to fledgling businesses, which results in an increase in IPOs and a resulting increase in competition in the broader business environment. the increase in available capital also decreases the cost of capital (this is intuitive stuff). these are in schweser, not sure about CFAI.
Awesome …Thanks everyone!
Cost of capital is higher in EM, because capital is more scarce. It simple supply/demand concept, supply of funds is not sufficient to meet demand in EM, therefore cost of capital is higher. After liberalization, borders are opening and some restricitions on foreign direct investment are removed, therefore supply of funds is increaing, and cost of capital is going down. However, since market is not completely open to foreign direct investment (like developed markets are) cost of capital is stil higher relatively to developed markets.