'Essays on Emerging Markets Finance' DPhil Dissertation, Michaelmas by lso20334


									                            ‘Essays on Emerging Markets Finance’
                             DPhil Dissertation, Michaelmas 2006

Standard portfolio theory predicts that individuals hedge risk optimally and allocate resources
efficiently. In simple models, assuming mean-variance efficiency, all investors hold the same
globally diversified portfolio. In richer models, the investors can reduce the risk of their
portfolio by diversifying across assets and markets. Emerging markets (EMs) provide
investors with substantial investment tools to diversify, particularly due to their low-to-
negative correlations with the developed markets. Therefore, consistent with the theory, the
foreign investors should be allocating a considerable part of their holdings into EM assets.
However, this is not the case in practice, and there is significant evidence for home bias in
global financial markets.
       Two of the suggested explanations to the ‘home bias puzzle’ are: the existence of
nontradables and the high costs to (small net gains from) stock portfolio diversification. The
nontradables exist either because of literal immobility of goods or barriers to cross-border
trade. The latter is relevant to the EM assets. The investors face two types of
restrictions/barriers while investing into EMs: direct and indirect. In this thesis, I provide
evidence on the significance of indirect barriers. In particular, I examine the impacts of
information asymmetries, lack of investor awareness, liquidity risk and low levels of capital
market integration, on stock prices.
       In the first paper, “Index Inclusions in Emerging Markets”, I study the price impacts
of changes to a benchmark EM index. The aim is to see whether this event has different
impacts and implications in EMs than developed markets. This subject of index inclusions has
been widely studied for the US market, though not for EMs. I approach this subject with a
new and extensive dataset of 269 stocks added to and 262 deleted from MSCI EM index,
during 1996:2004. I am interested in both the transitory and permanent price effects, so the
empirical tests are designed to test for these, separately. The empirical analysis is based on
event-study methodology. In the short run, I examine whether the index changes have any
information content and whether the price effects can be explained by changes in aggregate
demand. The results show that the transitory price impacts are smaller than, but similar to
those in developed markets, though smaller. The cumulative abnormal returns are 1.6% (-
3.2%) around inclusions (exclusions). I find evidence for increased aggregate demand from
both arbitrageurs and index funds, documenting limited arbitrage opportunities around the
index changes. The price impacts are permanent (temporary) following the inclusions

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(exclusions). In the long run, I suggest liquidity and enhanced market integration hypotheses,
to explain this permanent impact. The results support the latter, i.e. the permanent increases in
prices following the inclusions can be explained by the increased investor awareness and
integration (market betas) with the world markets. The main findings of this paper are: in
EMs (1) the price impacts are similar to developed markets only in the short-run (2) index
inclusions are events with information content and permanent price impacts; (3) in the short-
run, there are limited arbitrage opportunities; (4) in the long-run, the inclusion results in
enhanced investor awareness and market integration. Overall, these demonstrate the
significance of information asymmetries and investor awareness, on cross-border investments
in EMs. The results also provide evidence for the gradual, but continuous integration with the
world markets.
        In the first paper, the results of the liquidity analysis are rather surprising and
unexpected, but nevertheless interesting. I find evidence for increases in liquidity following
both the index inclusions and exclusions. Motivated by this finding, in the second paper I
study whether liquidity is a priced risk factor in emerging markets. If it is a significant indirect
barrier, then there should be an illiquidity premium in the stock returns. The title of this paper
is ‘Asset Pricing Implications of Liquidity in Partially-Segmented Markets’. I study this issue
by using a dataset, which consists of the daily stock data of the constituents of MSCI EM
during 1998:2005. This covers 823 stocks from 26 EMs. This sample represents the EM
stocks that foreign investors are aware of. Though liquidity has been previously studied for
the developed markets, its asset pricing implications in EMs has not been the focus of any
studies. In this paper, the pricing of liquidity is analysed within the context of capital market
integration. My hypothesis is that if the emerging markets are fully integrated with the world
markets, these stocks should be subject to common systematic risk factors, including liquidity,
which is priced in global markets. To test for this, I conduct a panel-data analysis with fixed
effects estimation at monthly frequency, based on a multifactor asset-pricing model. Three
different measures of liquidity are used; bid-ask spread, illiquidity measure and turnover rate.
The results are rather unexpected, contradicting the theory predictions and findings for
developed markets. The main findings of this paper are (1) there is no illiquidity premium in
EMs; (2) liquidity is a significant risk factor with a positive relationship with returns. I test for
Granger-causality between liquidity and returns, as a possible explanation for (2), however, I
do not find any evidence. Alternatively, I suggest that this may be the result of increased
international demand for the high-return and relatively illiquid EM stocks, in which case these
assets become tradable through alternative investment tools like mutual funds.

Summary                                                                                            2
           In the first two papers chapters of this dissertation, I suggest the ‘low level of market
integration’ as a potential explanation to asset pricing anomalies observed in EMs. In the third
paper, ‘Revisiting the Integration of Capital Markets: New Evidence from Emerging
Markets’, I empirically test for this argument by studying the significance and influences of
global and local risk factors on asset prices for the most integrated group of EM stocks. The
sample consists of the largest 50 stocks listed in MSCI EM, with daily data between 1996 and
2002. These stocks are assumed to be more integrated with the world markets, since the
international investors are already aware of and investing in these stocks. I also study whether
the EMs can be perceived as a homogenous asset class or whether it is still possible to
diversify across different EMs. The theory predictions are that if EMs are fully integrated with
the world markets, the assets should be priced by common risk factors, globally. If there is
complete segmentation, only local factors price the assets. In between these extreme cases,
there is mild (partial) segmentation, in which case both global and local factors are significant
in asset pricing. I test for these hypotheses by using international versions of CAPM and APT,
with pooled OLS and GLS. The global factors are proxied by the world index, oil prices, US
index; regional ones are emerging markets bond and stock indices, and local factors are
proxied by local stock index, sector index and exchange rate.1 The main findings are: (1) EMs
are partially segmented from world markets and local factors dominate; (2) risk reduction
benefits of diversifying across EMs is higher than diversifying internationally, 28% and 13%,
respectively. Among the local factors, the national stock market factors dominate with a
positive and highly significant coefficient.
           The findings of the second paper demonstrate that liquidity has positive asset pricing
implications in EMs. This result also has implications for the liquidity results in the first
paper. In the index inclusion paper, I find that liquidity increases following both inclusions
and exclusions; larger around the latter. However, in the light of the second paper, it may be
useful to revisit this result. It may actually be the case that the index inclusions do not have
any significant impact on liquidity, since MSCI includes stocks that already meet the
minimum liquidity guidelines.2 Since these stocks have already reached a certain liquidity
level before the event, there is no significant liquidity increase induced by the inclusion.
However, the case of deletions may be different and noisier. Illiquidity may be a much
stronger criterion for a stock to be excluded from the index, i.e. if a stock is illiquid, it will be

    The coefficients on these variables are not reported in this summary, since they vary among stocks.
    Please note that this doesn’t make the liquidity the only criteria.

Summary                                                                                                   3
deleted from the index for certain, but the fact that a stock is liquid is a necessary but not
sufficient condition for inclusion. Therefore, the liquidity effects may be much stronger and
apparent around exclusions. This argument is also consistent with the liquidity results. I show
that after the exclusion announcement, there is a significant price decrease, which means
higher returns. If returns are higher for more liquid stocks in EMs, then the liquidity increase
documented in the first paper, is no longer counterintuitive, but can rather be seen as a
manifestation of the positive liquidity-return relationship in these markets. Therefore, the
unconventional finding of ‘liquidity increase after exclusions’ may be explained by (1) the
positive liquidity-return relationship; (2) liquidity being a stronger criterion index exclusions.
       Similarly, the results of the third paper are closely linked to the first paper. In the third
paper, I find that local factors dominate global and regional factors in EMs, even for the more
integrated stocks. This is consistent with the finding that foreign investors face significant
information asymmetries in EMs, as documented in the first paper. If local factors dominate,
then information on these factors is more valuable regarding asset pricing. Local investors,
naturally, have better and easier access to this information, both at macroeconomic and
microeconomic (company) levels.
       This thesis contributes to the existing literature by providing quantitative evidence for
the significance of indirect barriers on cross-border investments to EMs. All three papers
present a clearer picture of the portfolio allocation decisions of international investors, and
factors that affect the asset prices in these markets. In each paper, I use an original data set on
individual EM stocks, at daily frequency, whereas previous studies on EMs mostly use
aggregate market data at lower frequencies. Additionally, I use panel-data methodology,
which has not been the common practice in earlier papers on EMs, mainly due to data
unavailability at individual stock level.
       Overall, the results document problems in EMs associated with the indirect barriers to
cross-border investments. However, their negative impact can be reduced by the right policy
tools. The main policy implications of these findings are on the issues of high costs to
international diversification and liquidity in the secondary markets. The high information
costs in EMs and the resulting information asymmetries decrease the net gains from portfolio
diversification. Particularly, given that EMs are partially segmented and local factors
dominate the asset prices, lack of access to local information is a significant obstacle to
foreign investment. Therefore, the policy-makers should target this by making information
more accessible and compatible with global standards. Policy actions can be taken to enhance
liquidity in secondary markets, since the investors face a substantial risk of illiquidity in EMs.

Summary                                                                                           4
If foreign institutional investors can be convinced to invest, this may decrease the impacts of
both of these problems. First of all, since these investors face lower investment costs
(including information), their gains from diversification may be much higher once
information asymmetries are reduced. Additionally, the individual foreign investors can also
invest in EMs through these institutional investors, like mutual funds. The existence of these
investors in EMs, also enhances liquidity, thus decreases the illiquidity risk smaller investors
face. Therefore, a plausible strategy for the policy makers is to promote foreign institutional
investment, by creating a more hospitable investment environment. This can enhance both the
liquidity and the total portfolio flows into EMs.

Summary                                                                                       5

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