[MUSIC] Hello, this is me again, Ines. Today we're going to talk about emerging markets, equities and bonds. After this video you should be able to describe the relative capitalization of emerging market equity. Understand the market development of emerging markets, define investibility, and measure investable weight factor, describe the risk and return characteristics of emerging market equity, and understand all the risk considerations and investment barriers that you should be aware of when thinking of investing into emerging markets. So let's start with the size of emerging markets. In terms of market capitalization, emerging market equity represents about a quarter of the total world market cap. So, if it's optimal, we'll see when it is optimal to do so, if it's optimal for you to hold the world market. You should be investing, a quarter of your portfolio should be allocated to emerging markets. So that's a large size. A large investment opportunity. Now, we know that emerging markets have high growth, high GDP growth, but their market cap is still only a small fraction of their GDP. And this market capital GDP is usually used as an indicator market development. So, as you see here in this graph, we're showing this market capital GDP ratio for some development markets, these are the green bars, and some emerging market this are the blue bars. And as you can see here, the market capital to GDP ratio, for example for Switzerland, exceeds 150%. While for a market such as Mexico is barely 30%. What could increase this market cap to GDP ratio? Remember, the market capitalization is, right, is that price of the stock times the number of shares, and then at the market level we are just aggregating this market cap of each stock. So to increase this market cap we need more listed stocks, or higher price, or both? So privatization, for example, is a way to increase this market cap. And emerging markets embarked into privatization during the 90s, and they continue to do so. Now not all of this market cap is investable. So what's this investability? So the investable weight factor is defined as what minus the sum of the percent held by strategic holders. Let me take an example. If we show that we have 1 million shares of a stock with A, where to have 1000 means 20% are held by family owner, another 10% held by the local government, and another 10% held by another publicly traded company, call it B. So the investable weight factor is what, is 1 minus the sum of the 0.2 plus 0.1 so that's 0.1 minus 0.4. That's a 0.6 investable weight factor that we also call a free float. Now investability should also take into account foreign ownership limits. And emerging markets have embarked into financial liberalization. And many reforms have helped to open their market to faultiness. If we compare investability in 1992 and 2008 for example, we see that for many emerging markets, investability has increased. For example, for Mexico, only 10% of the market was investable, meaning legally practically available to for investors. Now, more than 80% of the market is open to for investors. Why we care about liberalization? It's important because it has an impact on valuation of emerging market equity. And as we talk more about how to price securities, we'll understand better what happens, but actually what happens is that the price of emerging market equity increase following liberalization and increased investability. Now, when we say that these are markets are, legally, practically open, doesn't mean that foreign investors are coming and investing. It could be that they are not. They are shying from these markets because of implicit barriers. We have explicit barriers and implicit barriers, and when we talk about explicit barriers these are withholding taxes. The fact that you cannot, for example, repatriate your capital, or foreign exchange controls,, so all these are explicit barriers. Now, implicit barriers take the form of lack of familiarity. You don't know the language, you cannot read, say Chinese, so you cannot read the financial statements of Chinese companies. Or you feel that these markets are quite opaque, are not transparent. You are concerned about governance issues at the state level and at the corporate level, at the state level you fear expropriation by the state for example. At the corporate level, you fear that there is, the manager is trying to extract private benefits control. So these are examples of barriers that could push investors away from investing into these markets. There's another issue here, is what we call the home bias, the fact that investors prefer to invest at home. So they overweight their local stocks and underweight the foreign stock. And this is quite a general phenomenon, it is not only particular to when we talk about investing into emerging markets. Let's now see the return and risk characteristics of emerging markets, and actually we have seen some of this numbers if you recall, when we talked about in basic finance video. We show that emerging markets offer higher average returns compared to developed markets, as you can see it here as well in these tables. But also, they have higher volatility. And in terms of reward to risk ratio, they can offer higher reward to risk ratio, compared to some developed markets. So as you see here, some of the emerging markets are for higher reward to risk ratio, but remember you should not only be looking at the average return and volatility, we should also consider what happens in the tail of the distribution of the returns. Why this high average return for emerging markets? This is because of higher risk, so what type of risk are we talking about? Here, we're talking about, for example, political risk, or in general country risk that encompass political risk and economic risk. We have seen that with Michelle,, so political risk is this, associated with the willingness for the country to pay and economic risk and financial risks are associated with the ability to pay. So as a foreign investor, you would want to go and invest in more stable countries. Many services provide us with this risk ratings. For example, the political risk serves us international country with plotted here show as that Switzerland is a safer country. So here, a higher rating means higher political stability, lower political risk compared, say, to India. What are the risk considerations? There is also macroeconomic risk, risk of uncertainty in GDP growth, and inflation. Liquidity risk, this is quite important for emerging markets, emerging markets are less liquid than developed market equity. High transaction cost, high price impact, if you try to trade a large block, prices could move against you, and there's also this currency risk. Currency risk is an issue whenever you try to invest abroad, because you care about your local currency returns, and these are equal to the return that you can achieve in the foreign investment, plus the change in exchange rate. So part of the volatility of your returns are due to currency risk. And currency risk is particularly important for emerging markets because of the volatility of their currencies, but actually still the case that a lot of the volatility is due to equity returns. So currency risk, especially over the long term, is not important for equity. So to summarize what we learned in this video and what you should be able to do after this video, is to describe the relative capitalization of emerging markets and their degree of market development. Define investability and measure the investable weight factor. Understand the investment barriers, explicit and implicit barriers. Describe the return and risk characteristics of emerging market equity. And understand other challenges and risks when investing into emerging markets. [MUSIC]
