Lecture 5: Emerging Stock Markets. Dr. Edilberto Segura

1.

EMERGING CAPITAL MARKETS

Lecture 5: Emerging Stock Markets

Dr. Edilberto Segura

Partner & Chief Economist, SigmaBleyzer

President of the Board, The Bleyzer Foundation

January2010

I.Development of Emerging Stock Markets

II. Emerging Stock Market Indexes

III. Emerging Stock Market Performance

IV.Investment Vehicles in Emerging Stock Markets

V.Differentiating Features of Stock Exchanges

VI.Structure of Stock Markets

VII.Enabling Environment for Emerging Stock Markets

VIII.Equity Portfolio Strategies and Building an Emerging Market Portfolio

Emerging Stock Markets have developed rapidly during the last decade, with stock market capitalization growing from US$500 billion in 1988 to $20,950 billion by 2007, but they collapse by almost 60% to $8, 558 billion during the 2008 crisis (source: IMF):

2007 2008

Asia$13,782 $5,327

Latin America$2,292$1,456

Emerging Europe$2,417$641

Africa$1,181$444

Middle East$1,276$690

The largest markets are in East Asia,including China, Taiwan, and India. In Latin America, the markets in Brazil, Mexico and Chile grew rapidly. In Emerging Europe, Russia grew fast.In Africa, stock markets developed in SA, Egypt, and Morocco.

Six EM countries account for over 50% of the stockmarket capitalization of all EMs: Russia, India, China, Korea, Brazil and Taiwan.

However, EMs are still small in size compared with developed countries :the market capitalization of EMs of 20.9 trillion is only 32% of the world equity capitalization of $65.1 trillion in 2007.

Nevertheless, the stock market capitalization of countries such as Russia, India and China are in excess of US$700 billion and are comparable in size to those of many developed countries.

Key Statistics for selected EM countries are given in the following tables.

($ billions)

2004 2005 2006 2007 2008

Europe 6 11 18 377

(Ukraine) -0.2 0.1 1.3 0.9

Middle East 2 5 8 13 4

Africa 3 1 4 9 1

Latin America 2 6 15 48 13

Asia 36 63 79 101 28

Total49 86 124 207 54

Source:IMF, Sept 2009

Country S&P Equity #Listed Price/Earnings (PE)Ratios

Rating Issuance Compies 00 01 02 '03 '05 06 07 08

Abroad($bn07)

Taiwan AA- 5.3 540 35 15 30 17 13 14 16 9

Brazil BBB- 38.8 4401799 11 10 12 17 7

South Africa BBB+ 6.9 58013 10 128 14 15 15 8

China A+ 60.7 114845 47 449 13 20 27 6

Mexico BBB+ 2.9 12612 14 15 15 14 15 14 9

India BBB+ 22.2593819 10 129 17 19 26 10

Russia BBB 33.5245 10 na712 17 17 22 4

Malaysia BBB- 1.9809 24 12 19 12 11 17 15 15

Chile A+ 0.5255 23 16 16 21 18 19 19 13

Argentina B- 1.3 120 14 15 14 12 9 11 16 7

Korea A 7.4 135048 17 11 11 11 15 10

Philippines BB- 2.6230 20 13 16 12 11 16 14 15

Thailand BBB+ 1.0440 13 149 11 10 7 14 5

Indonesia BB-3.1 30788 18 10 12 18 21 21

Hungary BBB 0.2 56 na na 16 12 19 14 15 6

Czech Rep A 0.3 124 na na9 14 24 25 26 9

Ukraine B1.3 280na na na na na na nana

All EMs 207 18000

All Developed 20600(US: 2628202219182211)

World 38600

Local stock indexes of Emerging Markets are seldom used by foreign investors because of their lack of comparability.

Investor prefer to use emerging market benchmarks prepared by recognized international institutions.

The performance of managed portfolios investing in EMs is normally measured relative to these EM indexes.

The main EM indexes are:

S&P/IFC Indexes,

Morgan Stanley Capital International indexes (MSCI),

ING Baring Indexes,

Goldman Sachs-Financial Times Indexes.

Some of these Indexes are available through the Internet.

Sector Indexes (such as industry, telecommunications) are also published.

1.S&P/IFC Indexes

Since 1984, the International Finance Corporation (IFC) of the World Bank published, on a daily basis, several indexes for EMs. In April 2000, this business was purchased by S&P.They include:

S&P/IFC Global (S&P/IFCG).

It covers 32 emerging countries (2,000 stocks), three regional composite indexes (Latin America, Asia, and Europe & Middle East), and industrial sector indexes.

For each country the target aggregate market capitalization is between 60% and 75% of the total capitalization of the stock exchange.

S&P/IFC includes only the most actively traded stocks.

Corporate cross-holdings & Government ownership of shares (that are not traded)areeliminated.

S&P/IFC seeks industry diversification.

Each stock enters the index in proportion of its capitalization.

S&P/IFC Investable Index (S&P/IFCI).

It measures the market for sharesavailableto foreign investors.

It is useful for foreign investors (i)to benchmark their own performance; and (ii) for passive management investments.

Adjustments are made to reflect foreign investment restrictions (the weights of China, Taiwan, Korea and India are reduced significantly , and Nigeria is eliminated).

Stocks must pass size and liquidity screens.

S&P/IFC Frontier Markets.

It was introduced in 1996 for 19countries that were borderline but could eventually meet selection criteria when trade volume and liquidity increases.It is published monthly.

The S&P/IFC indexes include financial information, such as: P/E ratios, P/Book Value ratios, and dividend yields.

2.Morgan Stanley Capital International indexes

(MSCI)

Since 1988, Morgan Stanley Capital International (MSCI) issues two main indexes for 20 Emerging Markets on a daily and price-only basis:

MSCI Global

MSCI Free, which includes investable stocks.

For each country, the target market capitalization is 60% .

The MSCI indexes are more selective that IFCs in choosing stocks:

Efforts are made to have very close representation of industrial sector coverage (a key difference with IFCs).

Closely-heldand multi-industry companies are eliminated.

MSCI also publishes composite international indexes:

Emerging Markets Global (EMG) with 700 stocks, and

Emerging Markets Free (EMF), with 600 stocks.

3.ING Baring Indexes

Since 1992, Baring Emerging Market Indexes (BEMI) have been covering 20 countries (about 500 stocks), on a daily basis.

It is more selective and less comprehensive than IFC or MSCI.

It includes only major, liquid stocks that meet strict standards of availability to foreign investors.

Each national index consists of 10 to 35 stocks weighted by their market capitalization.

ING Baring also publishes a BEMI World Index and regional indexes.

Foreign investment restrictions are reflected in the weightings.

The indexes are calculated on a price-only and on a total-return basis.

4.Financial Times - Goldman Sachs Indexes

The Financial times,with the collaboration of Goldman Sachs produces the FT-Actuaries World Indexes for Developed Markets.

Since 1994, indexes for a number of Emerging Markets, have been added.

For each index, the following information is provided:

Price Index for last three days.

Two-year high.

Two-year low.

Yield.

P/E Ratio.

A.Returns from EM Stocks

The evidence from empirical studies on whether EM stocks have higher returns than in the USis mixed .

A 1998 study published in the Financial Analysts Journal found that, as a group,EMs have not produced levels of returns higher than the US market, while being more volatile. Indeed, the US did very well in the 1990s until 2000 and then collapsed in 2001.

Other studies have shown that, over a longer number of years, excess EMreturns over the S&Ps has been around 4% to 8% pa.

But all studies show that the correlation with the US market is low enough to provide risk diversification benefits.

Empirical studies show that EM equity prices are correlated with therate ofGDP growth ,country risk , and theflows ofdirect foreign investments , all of which are affected by macroeconomic policies.

These studies show that sudden increases in foreign direct investments areearly indicatorsthat stock prices will increase.

Studies also show that EM equity prices tend to increase faster during the initial period of "emergence" -- (turn around in economic performance), not much before, not later on. Investors who can detect a forthcoming change in policies can enjoy large returns.

For the US, studies show that equity prices are positively correlatedto expected earnings and negatively correlated to interest rates.

B.Volatility of EM Stocks

Equity pricesin EMs have been characterized by wide fluctuations, greater that that of developed markets.

For example, South Koreas stock price index evolved as follows: 1986-89: a 400% increase; 1989-91: a 35% drop; 1991-1994: a 70% increase; 1994-1998: a 70% drop; 1998-1999: a 400% increase; 1999-2001: a 50% drop. By April 2003 it was 10% up from mid 2001.

This highvolatility inequity prices is the result of:

Inconsistent application of economic policies in EMs that leads to periodic financial crises.

Thin, narrow markets for most EM securities.

The tendency of investors to be driven by the herd due to poor information.

EM price volatility does not follow a normal distribution or any symmetric distribution of returns.As a result, the probability of a large negative price movement can be high.Therefore, the standard deviation is not a sufficient measure of market risk.

Empirical statistical studies also show that equity price volatility is correlated toinflation rates : countries with high inflation tend to have larger stock price volatility,

Inflation, in turn, is caused by the adequacy offiscal policies(the size of fiscal deficits) andmonetary policies(the balance betweenmoney supply and demand).

EM equity prices drop drastically during periods offinancial crises .

The most fundamental causes of a financial crises are inadequate macroeconomic policies, which produce unsustainableexternal imbalances(high current account deficits) andinternal imbalances(high fiscal deficits or low private savings).

External and internal imbalances lead to internal instability (high inflation)and external instability (currency devaluations).

The wide fluctuations in the stock prices of EMs should not dissuade investors, given potential returns and diversification benefits.

But investors should resist the temptation to go to hot markets in fashion; instead, they should look at the fundamentals of each market.

The lesson from the 1990's crises is that investors in EMs shouldnot just look at the financial statements of companies.A fundamental analysis of the overall economy is required.

Total Dollar Return Performance in EMs

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

MSCI EM Free -31.8 -4.9 -8.0 51.6 22.4 30.3 29.1 36.8 -54.4 74.1

Latin America -18.4 -4.3 -24.8 67.1 34.8 44.9 39.3 46.9 -52.8 98.1

Asia -42.5 4.2 -6.3 47.1 12.2 23.5 29.8 38.3 -53.9 68.9

Eur, ME & Afr -23.4 -17.7 4.7 51.2 35.8 47.1 21.3 28.9 -56.5 63.3

Comparators:

World -14.1 -17.8 -21.1 30.8 12.8 7.7 17.9 7.1 -40.3 31.5

US -9.1 -13.0 -23.4 26.8 8.8 6.4 13.2 5.6 -37.4 26.3

In 2007, Ukraines stocks had the one of the highest rate of growth in the world.

This growth was supported by the creation of all-Ukrainian stock indexes in the Vienna Stock Exchange that led several banks (such as ABN-AMRO) to create products based on this index.

But during 2008, Ukraine stock exchange was one of the worse performers in the world, loosing 70% of its value. But it recovered somewhat in 2009.

Prices,

in US Dollars,

as of December 2008

The stock bubble of the 1990s (dot-com bubble) was due to the speculation that

a New Economy -- supported by better technology, computers, e-commerce and

other internet applications -- would generate higher productivity growth.

For several years, this led to a financing boom (supported by new Venture Capital),

higher investments and growth, high P/E ratios and high stock pricesuntil 2000!

Then anotherboom (in housing) was supported by low interest rates and de-

regulation of banks.until 2008!!.

Stock Prices,

in US Dollars,

as of December 2008

Investing abroad has been facilitated by the development of a number of equity investment vehicles.The main ones are the following:

1.Direct Purchases.

The direct way to trade in foreign equity is on the foreign stock market itself.

But this route is usually reserved for large institutional investors because of the issues involved:initial foreign exchange purchase, a custodian to hold the shares, a bank account to collect and repatriate dividends, pay commissions, pay taxes, etc.

In addition, the investor should be familiar with the issues of delivery, clearing, and settlements, as will be discussed later.

All these issues substantially increase the transaction costs of foreign stock markets.

Other simpler schemes are given below.

2.American Depositary Receipts (ADRs).

ADRs are negotiable certificates evidencing ownership of foreign equity shares held, on the investors behalf, by a major US bank in the foreign country where the shares were issued.

ADRs were first introduced in 1927 by J.P. Morgan to allow Americans the chance to buy shares in Londons Selfridges Department Store.Until that time, a physical presence of the investor in the country was needed.

In order to issue an ADR, a US bank takes custody of foreign shares in its own foreign office.

Then, an ADR can be issued as a claim against these shares.

The US bank will take care of all administrative matters, such as receiving dividends, paying taxes, keeping track of exchange offers.

Three US banks dominate the ADR market: Bank of New York (with 65% of the market), Morgan Guaranty, and Bankers Trust.

Owners of ADRs have the right to redeem their ADRs and obtain the true underlying foreign shares.This possible arbitrage ensures that the price of the ADR and the foreign shares will be very close, though there may be a discount.

Investors can trade their ADRs without recourse to the foreign equity market and without relying on foreign clearing and settlement; thus reducing trading costs.

In ansponsored ADR ,the foreign firm pays a fee to the depositary bank for the program cost.

In anunsponsored ADR , the depositary bank takes the initiative to profit from a popular foreign issue.

ADRs bear all the foreign exchange and commercial risks of the underlying foreign shares, even though they are quoted in US $.

Global Depositary Receipts (GDRs) are similar instruments trading in other countries, particularly in London and Luxembourg.

ADRs and GDRs are generally called DRs

Level 1 ADRs are those ADRs that are not traded in an exchange; but they trade in the over-the-counter markets. They do not require full SEC registration.The company is only required to disclose its Financial Statement in English and information provided in its home Annual Report (no need to GAAP accounting principles).

Level 2 ADRsare those that meet the disclosure requirements of a US stock exchange and are listed in the exchanges.

Level 3 ARDsare those that fully complies with US accounting principles and disclosure requirements, and they may raise equity in the US through a public offering.

Rule 144A ADRsare those privately placed with Qualified Institutional Buyers.As a private placement, there is no need of registration and review by the SEC.These ADRs can be resold only to other Qualified Institutional Investors.

In 2008, more that 2,250 sponsored DRs were traded in the US and Europe, from about 76 countries (from 350 DRs from 24 countries in 1990).

In 2008, the total value of outstanding DR's reached $1,800 bn ($1,200 bn listed in the US, $320 bn listed in Europe and $250 bn in OTC and others).

Demand for DRs have been growing, with trading volume reaching $24 trillion during the first half of 2008, increasing by about 25% pa during the last 10 years.

In 2007, foreign companies raised US$55 billion through DR offerings, of which $27 billion was handled by Bank of New York Mellon, $11 billion by Citibank, $10 billion by JP Morgan, and $8 billion by Deutsch Bank.

A large number of DRs are from Emerging Market companies,including India (276), Russia (195), China (143), Brazil (129), South Africa (69), Mexico (66), Ukraine (65), Korea (59), Turkey (53), Poland (38), Kazakhstan (24), Hungary (16), etc.

Ukrainian companies include metallurgical, auto, retailers, oblaenergos, banks, etc

The largest Emerging Markets companies raising funds in 2007-08 were Gazprom, Lukoil (Russia), Petrobras, Vale (Brazil), American Mobil (Mexico), and Suntech (China).

3. EM Mutual Funds.

These are organized as corporationswith a board of directors. Investors purchase their shares which are pooled and invested inEM securities.

Mutual funds can be Global (US and non-US shares), International (non-US shares), Regional (in a particular area), County (a particular country), or Sector Specialty (such as energy).

There are two types: Open-end and close-end mutual funds.

Anopen-end fundstands ready both toissueand toredeemshares,at prices reflecting thenet-asset valueof the underlying foreign shares (assets minus liabilities). The shares of the open-end fund are not normally traded in secondary markets.

Aclose-end fundissues a fixed number of shares against an initial capital offering. It will not redeem the shares but they aretraded in the secondary market at prices reflecting a premium or discount relative to the net-asset value of the underlying foreign shares.

The owner of a share of an open-end fund earns a return based on the change in the net-asset value of the fund.

The owner of a share of a close-end fund earns a return based on the net-asset value of the fund plus the change in discount/premium.

Studies in 1994/95 showed that, on average, the variance of close-end country fund returns is three times larger than the variance of the underlying foreign securities.

The premium/discounts of close-end funds are mean reverting and are affected by news about local events.

On the other hand, open-end funds are not practical or cost-effective for foreign investment in Emerging Markets.

This is because it is hard for an open-end fund to stand ready to liquidate stock positions on demand, since foreign equity emerging markets lack liquidity, impose higher transaction costs and restrict full liquidation/repatriation of positions.

Close-end funds are not forced to liquidate positions when shareholders wish to exit the fund.Exit or purchases will however affect the premium or discount of the fund shares.

Close-end country funds have become the fastest segment of the market in the last decade.

EMs country funds include funds for Argentina, Brazil, Chile, China, Mexico, Philippines,China, India, Indonesia, Korea, Malaysia, Taiwan, Thailand, Turkey, Russia, Ukraine, etc.

4. Index Funds

Index funds are investment funds whose shares are traded in stock exchanges and are intended to track the performance of a single country index.

Therefore, they are useful for investors who wish to follow a passive investment strategy.

Index funds started in 1987 when the Toronto Stock Exchange created a fund to hold baskets of the stocks in the Toronto 35 Index.

In 1993, the American Stock Exchange began trading shares in an index fund that held a portfolio of all common stocks in the S&P 500 (calledS tandard andP oorD epositoryR eceipts -- " Spiders" ).It was an instant success.

In 1996, the American Stock Exchange opened another index fund for international equities, the World Equity Benchmark Shares Foreign Fund).Its shares were called "Webs".They are now callediShares(for index shares).

The iShares fund has 20 separate portfolios, each one designed to match the performance of a given country, including EM such as Hong Kong, Mexico, Malaysia, Taiwan, Korea.

The iShare portfolios are designed to track the Morgan Stanley Capital International (MSCI) Index for that country.They are managed by Barclays (BGI).

The New York Stock Exchange in 1996 introduced its own Index Fund,Country Baskets .CBs were available for 10 countries and are designed to track the Financial Times/S&P Actuaries World Index for that Country. They are managed by Deutsche Morgan Grenfell.

CBs and iShares combine the features of close-end funds, open-end funds and ADRs.

To initiate the fund activities, they rely on the sale of a creation unit.In exchange for a sum of money (US$2 million for CBs and US$0.5 million for iShares), an investor purchase a creation unit in one index fund.

The fund manager uses these funds to buy shares and DRswhose performance will match that of the country index.

Each creation unit divides into a specified number of shares that the investor can sell through the corresponding stock exchange.

Thus, like an open-end fund, the size of the CBs and iShares can grow without limit; but the shares are traded at any time in the secondary markets, like a close-end fund.

As a DR, prices of CBs and iShares are kept close to the net-asset value of the underlying foreign shares, through arbitrage.

5.Hedge Funds

A hedge fund is an organization whose management receives compensation in the form of performance incentives, rather than the amount of assets held or transactions made.

Normally the managers are also large investors.

In the US, they are usually structured as Partnerships.

They raise funds asPrivate Placements : a private offering to a accredited investors (such as financial institutions) and no more than 35 non-accredited investors.The total cannot exceed 100 owners.Normally a typical investment is over $250,000.

Under a Private Placement, the fund avoids registration under the Investment Company Act of 1940, which imposes limitations on the types of investments made and requires strong disclosure.

If the Hedge Fund is organized outside the US -- calledoffshore fund-- it can avoid the limitations in raising funds.

Popular places with low regulations include Bermuda, Cayman Islands, Bahamas, Mauritius, Luxembourg, Switzerland, Dublin.

Originally, in 1949, hedge funds were introducedA.W. Jones and Co . to maintain highly leveraged but relatively diversified and "hedged positions, with a limited net exposure to overall price movements (they developed fast in the 1960s and 1970s):

Market Exposure = (Long Exposure - Short Exposure)/capital

Today, Hedge funds follows many different strategies:

Market neutral, where the market exposure is low or zero trading on convergence spreads between two securities.

Event-driven, seeking arbitrage in bankrupt securities.

Opportunistic, taking advantage of any opportunities.

Most hedge funds use derivatives extensively.

Investors normally have short-term horizonts, thereby the hedge fund must have liquidity by investing in short term deals

Because of risk management failures, hedge funds have suffered from a large share of failures.

Also, because of the lack of regulations, they have been more vulnerable to fraud.

In 2002, there were 6,000 hedge funds with $600 billion in assets.

It is a collective investment vehicle under which large investors ( Limited Partners ) providelong term financingto a Private Equity Fund ( General Partner ) for investment in firms that need initial capital ( Venture Capital)or capital for restructuring ( Buy Outs )

A professional fund manager (General Partner) monitors and manages the future growth of the invested companies

PE Funds have a defined life (10 years is standard)

PE Buy Out Funds invest in few large companies (10-15)

The GP receives a Management fees to cover costs (2% standard)

Additional Incentive for manager: Carried interest (usually 20% after a hurdle rate of 6 10% pa)

Private Equity Funds are organized as Limited Liability companies normally incorporated off-shore.

Funds are raised as Private Placements

PE can play a critical role in promoting economic growth and preparing companies for purchase by strategic investors

High growth.

Exceptional product /Intellectual Property

Need weekly & monthlyboard meetings and close monitoring

Financial Investors

Adds value

Professionalizes

May change Management

May merge

- - -Committed amount

______Invested amount

Contacts

Own network

Seminars

Cold Calling

Must fit

objectives

Feel for

economies

7.Equity-Linked Eurobonds .

Many Emerging Market companies issue Eurobonds with features such as detached stock options (warrants) andconvertibility that provide links to equity shares.

These features provide an alternative vehicles to invest in equity.

In a country which is largely closed to direct equity purchases from abroad, a convertible bond is one of the ways for a foreign investor to enter the equity market.

In other countries, such as Indonesia, with difficult equity clearing and settlement procedures, a convertible bond was used to avoid these equity market problems.

8.International Firms .

An indirect way to participate in the economy of Emerging Markets, is to purchase shares of international companies (US or European) that have a large portion of their revenues and profits from their activities in Emerging Markets.

For example, a large portion of the revenues of the UK company JKX Oil, Ltd.,depends on its oil investments in Russia and Ukraine.

Other large international companies with substantiveinvolvement in Emerging Markets include: American Express, Bayer, Coca-Cola, McDonalds, Gillette, Minnesota Mining and Manufacturing, Nestle, Unilever, Procter and Gamble.

Most EMs have established Stock Exchanges to facilitate stock trading.The key features of these stock exchanges are:

(1)Public versus Private Exchanges :

In most EMs,stock exchanges were established byGovernments, which retain strong influence in their operations.

Stock dealers and brokers are private, but operate under the surveillance of the state, normally through National Security Commissions.

Following the Anglo-American model, inSouth Africa and most of East Asian, stock exchanges are private, but operate under Government regulations, with a good doses of self-regulation.

(2)Spot versus Forward Markets .

In most markets, stocks are traded on a spot or cash basis.

But almost nowhere are stocks, once traded, delivered on the same day:a typical spot or cash settlement of the stock is three to five business days (T+3; T+5).

Many East Asian exchanges and Rio de Janeiro follow a forward market approach (such as in Paris):Stock deliveries and settlement take place once a month at the end of the month.At the time of the transaction, the price is fixed and a deposit is required.

(3)Continuous versus Auction Quotations .

Most major markets offer continuous pricing of stocks, at least for the major stocks, withmarket-makers ensuring liquidity.

Market-makers will quote both abid price (for buying)and a asked or offer price (for selling);and stand ready to trade at these prices.

In smaller markets, the price is determined bydaily auctions : orders are accumulated,and at the end of the day, a price thatmaximizes the volume of transactions is determined(this is the price where there is equilibrium of demand and supply).This single equilibrium price applies to all transactions.

(4)Centralized (Floor Trading) versus Decentralized Systems.

Centralized stock trading at the floor of exchanges continues in many exchanges, due to the advantages to close personal interactions, principally for large transactions.

But most stock exchanges in Emerging Markets usedecentralizedcomputerized systems as the forum for trading, following either(i)price-driven systems ;or (ii)order-driven systems .

These stock exchange systems have their own regulations regarding requirements for membership, access to the system, trading rules, listing and de-listing of securities, registration as market-makers, professional responsibilities, settling of disputes, arbitrage, etc.

Price-driven systems , such as Ukraines, are based on the NASDAQ system for low-liquidity stocks:

It is based on a dealerPrice Quotation System(Stock Exchange Automated Quotation- SEAQ).In Ukraine, out of 300 dealers, 200 are members, linked to the system.

Members are free to register asmarket-makers, quoting firm bid/asked prices for active stocks, up to a maximum limit.

The difference between the bidand asked prices is the spread which is the source of income for the dealer.

A 1994 Harvard study of the US NASDAQ, found that in many stocks, the spread was always $0.25 a share, while in others went as low as $0.12 a share. This prompted to accusations of collusion and a review of competitive practices. Soon thereafter, spreads began to shrink.

In this price-driven system, transactions do not happen automatically, but are executed at the order of a member dealer.

Once an order arrives to a market-maker, it is obliged to execute it.

Both parties are expected to input the transaction and reported it to the main system within 90 seconds.

If the receiver of the order does not execute it within a few minutes, the originator can input both entries and report it.

Some minor stocks have only a handful of market-makers; big company stocks have as many as 50.

The screen of a dealer would list bid/asked quotations by market-makers for a specific company stock,as follows:

Order-driven systemsare based on the Paris and Toronto systems:

All exchange members have trading screen in their offices.

For listed stocks, members enter theirlimit-orders , indicatingthemaximumprice for buyingthe stock (maximum bid price) and theirminimumprice for saleof the stock (minimum asked).

Trading takes place automatically against this computerized limit-order book.

When a new order arrives, if possible, it is immediately routed and executed against the limit-order book: it would be possible if the new order has a price for purchase that is above or equal to the minimum price asked by another dealer for the sale of the stock.

If it not possible to execute the order, it is entered into the limit-order book for future trading.

Since bid/asked orders are not of equal quantities, orders are executed following price/time/size priority rules: (highest bid and lowest asked have priority over other orders).

In some cases, large trades are done over the telephone, rather than left to the computer. Once executed, they are recorded in the computer and taken into account in price calculations.

In small stock markets, such as Moldova, trading is not continuous: Members enter their limit-orders between 10:00 am and 2:45 pm. At 2:45 pm entry is closed and orders are matched, as follows:

Max Bids (Buyers) Min Asked (Sellers)

Dealer Price # Shares Dealer Price # Shares

A4.0300D3.0100

B2.0500E4.0100

C1.0200F5.0100

The only transaction that would take place is the purchase by dealer A of 200 shares, 100 from dealer D at $3.0/share and 100 from dealer E at 4.0/share.The average price will be $3.5 per share, which will be registered for the records.

The following chart provides a graphical representation of the structure of stock capital markets:

TheLower Level (Level 3)includes the Shareholders .

Their share ownership is formally recorded -- for a fee --in specialized entities called Registrars .

Registrars will issue Certificates of Ownership, either in paper or dematerialized (electronic) form.

There are about 30 specialized Registrars in the US.

In many EMs, any agency could be a Registrar, including the same company (until recently, there were 400 Registrars in Ukraine; in Russia, owners disappear before dividend payment date).

The independence, qualification and regulation of Registrars is a key factor to avoid abuses and give confidence to a stock market.

Level Twoincludes the Custodians (dealers, brokers, banks) which represent the shareholders, keeping their shares in custody, either physically or electronically (paperless).

The Custodiansare only entities working with Level Oneagencies and Level 3 entities. There are 5,000 in the US; 60 in Ukraine.

TheLevel Oneagencies include:

The Trading Systems:Stock Exchanges and Over-the Counter, where the trading takes place.

The Depositary:which receives from Custodians the shares to be sold and keeps them in anticipation of the trade.

A centralized, independent depositary is key to give confidence to the market.

The Settlement Bank:which keeps the cash accounts of buyers.

The Clearance and Settlement System:

Trade clearance involves verifying and comparing information provided separately by buyers and sellers and finding out whether there is a match. Otherwise, they go back to the dealers.

If the match is successful, settlement obligations are calculated.

On T+1 to T+3 day, it will check that the sellers shares are indeed deposited in the Depositary and that the buyers do have cash in their accounts in the Settlement Bank.

If so, it instructs the Depositary to transfer the securities from seller to buyer; and gives the order to the Settlement Bank to transfer money from the buyer account to the seller account.

Settlement can be made on a gross basis for an individual deal, on a bilateral net basis for more than one trade among two parties, or on an multilateral net basis (the last one is typical in the US).

A key function of this system is to protect shareholders rights and provide confidence that payments will be made only if there is delivery of the securities.

A Delivery-Versus-Payment (DVP) system has controls toensure that final delivery of securities (or cash) occurs only if final transfer of funds (or securities) occur.

Many EMs have non-DVP systems, with the risk that the full amount of the transaction may be lost.

In Europe, the tradition is to combine the functions of Depositary with Clearance and Settlement Houses.

For example, in Switzerland, the securities transfer system SECOM is linked to a separate fund transfer system, SIC.

A DVP transaction causes securities to be reserved in SECOM, which then generates a payment instruction from the buyer to the seller in SIC.

SECOM releases the securities to the buyer when SIC confirms final payment.

In the US, the functions of Clearance and Settlement Houses and Settlement Banks are performed by the National Securities Clearance Corporation (NSCC) and the US Federal Reserves Fedwire Securities and Fund Transfer Systems.

In the books of the Federal Reserve, banks maintain both security and fund accounts, which permits simultaneous transactions.

In the US, depositaries are organized as limited-purpose trust companies under banking laws.

Investing in equities in EMs has special risks, including:

(a)Information Barriers .Differences in accounting standards, and high cost of information.

(b)Political and Capital Control Risks .As a foreign investor, you money is under another jurisdiction.What are the protections you enjoy.

(c)Foreign Exchange Risks .The value and returns from the equity is denominated in a foreign currency.Is there convertibility or restrictions on foreign exchange?

(d)Restrictions on Equity Investments .

(e)Excessive Taxation .

(f)High Transaction Costs .

The way how the country deals with them defines the quality of the enabling environment for stock market development.

In assessing the adequacy of the enabling environment for capital markets in the country, the following matters should be analyzed:

1.Adequacy of the Legal and Regulatory Framework for the Stock Market.

Does it provide adequate protection ofownership rightsfor small and other shareholders?

Does it contains adequate and severepenalties for fraud ?

Does it permit sufficientcompetitionto facilitate stock trading and reduce transactions costs?

Are the Broker/Dealerregulationsadequate in terms of net capital requirements, qualification standards, commission limitations, auditing requirements?

Is there a system ofself-regulationby market participants?

2.Adequacy of Prudential Supervision of Capital Markets.

Is thesupervision systemcapable of detecting abuses, insidetrading?

What is the role of the national security and exchangecommission ? Are there conflicts with other agencies?

Are the procedures adequate to carry outinspections, off-site and onsite surveillance ?

How areprudential regulationsenforced on market participants?

3. Adequacy of Information, Accounting and Auditing

Standards .

Are thelisting requirements , including documentation of qualitative and quantitative qualifications, satisfactory? excessive?

Do the listed companies comply withinternational accounting and auditing standards ?

Are the requirements fordisclosure of informationsatisfactory for Public Offerings? Private Placements?

Do they provide for information through Annual Reports with adequatetransparencystandards, such as compensation of managers?

4. Adequacy of Tax Policies for stock market activities.

Dotaxesunduly penalizes capital market transactions and profits?

5. Adequacy of the Stock Markets Infrastructure.

Does the currentmarket infrastructureprotects fromcounterpart risk:the possibility that the other party (seller or buyer) will not deliver at settlement.

Does a central and independentdepositary systemexist to minimize abuses and risk of non-delivery?

Is there an adequate system forregistration and custody of shares ? (is an accurate custody of ownership records maintained? will shares be wrongfully lost, challenged?

What systems are used to handle the formalClearing Process ? (process of verifying and identifying the traded shares, the identity of buyers and sellers, and the price and date of trade)

How good is the system for thesettlementof stock transactions (time periods, level of technical fails, adequacy of the delivery-versus-payment system, netting process?)

What is the level oftechnologysophistication and types of risk controls are used in clearance and settlement?

What are the sources oftrade dataand how it is reported?

What is the peak and normalprocessing capacityof the existing infrastructure?

6.Availability of private and sound Credit Rating Agencies.

The availability ofcredit rating agencieshas been proven to be a key factor leading to better market discipline and transparency by listed companies.

Credit Rating companies exercise a good degree ofmarket control.

The main argument for global investment -- and particularly for portfolio allocation in emerging capital markets --is basedon the appeal of diversification (to reduce the total risk of a portfolio).

The risk of an EM stock is defined by the volatility of its returns.

Butcontrary to the US situation, the "standard deviation" of returns is not a good measure of risk, since they do not follow a normal or symmetric distribution.To assess the risk of the EM stock, the investor must look at the economic situation of the country.

Empirical work has indeed shown that EMs stocks are more volatile that stocks in developed markets.But since correlation with other markets is low, EM stocks can actually reduce portfolio risks while keeping or increasing returns.

Correlation Risk

A form of international portfolio risk iscorrelation risk :The risk that a seemingly diversified portfolio will prove to be un-diversified in the future because its assets will begin to move uniformly, rather than independently.

Increasing cross-border investments and improved communications is increasing the correlation among developed markets.

But except during periods of large variations, correlations of developed market stocks with emerging market stocks are still low.

These correlations are still low due to the fact that emerging markets are still segmented in an international context.

This segmentation is due to market imperfections and constraints, including:lack of information,Government constraints, investors perceptions, etc.

Although, long term gains from diversification are feasible, portfolio managers should be aware that in times of large market movements almost all markets seems to move in the same direction:During periods of disaster there is no safe place to hide.

However, the impact of a crisis on other individual EM depends on the economic strength of the country: Countries with sound economic policies have suffered less from crises.

All this suggests that rules-of-thumb do not work well in EMs. Investors should carefully build their own Emerging Market Portfolio based on fundamental analysis.

Building an Emerging Market Portfolio

The stock selection process could follow a Top-Down approach or a Bottom-up Approach.

(1)Top-Down Investing .

Under this approach, a country (sector) should be selected first, based on fundamental macroeconomic factors.

This approach is based on the believe that stocks within a country (sector) are highly correlated and move together.

Therefore, the emphasis is put in identifying countries (sectors) that are expected to outperform.

After a country (sector) is selected, then, stocks can be chosen within the selected country:Most Top-down investors would use a passive management for stock selection (such as using a country index).

But others would use active management (picking up individual stocks).But since stock selection is less important, they tend to concentrate in large, liquid stocks.

In order to forecast the relative performance of the countrys stock exchange, there is a need to look at the soundness of the economy as a whole.

A sound economy is one that has bothgrowth and stability .

Growthis defined by a high rate of GDP growth.

Stabilityis defined by a low inflation rate ( internal stability ), and a stable foreign exchange rate ( external stability ).

Sustainable rates of real GDPgrowth and firm stability are the key factors affecting the performance of the stock exchange.

Growth and stability are secured by the implementation of sound economic policies.

The following economic policies have been proven to be essential (I for Stability; II and III for sustainable growth).

(I)Macroeconomic Stabilization Policies:

Fiscal Policies under which the Government's fiscal budget has a deficit that can be financed by borrowings on a sustainable basis (normally no more than 3% of GDP).

Monetary Policies, under which the creation of money (money supply) will not exceed the demand for money (which is affected by income and interest rates).

(II)Liberalization of the Economic Environment

Liberalization of the Formation and Operation of Enterprises

Liberalization of the Closure of Failing Enterprises

Liberalization of Product Pricing and Trade

Liberalization of the Financial Sector

Liberalization of Labor and Land Markets

(III)Good Public Governance with Sound Institutions

Sound & efficient Government services without corruption

Stable and predictable legal environment

Low political risks.

(2)Bottom-Up Investing.

These investors base their portfolio selection on the merits of individual stocks.

The emphasis is put on identifying stocks that are expected to outperform.

Country considerations are reviewed at a second stage, with emphasis on exchange rate movements and interest rate movements.

Individual company stocks are valued using similar tools to those used for other domestic markets.

Professional investorsoften screen thousand of EM stocks by applying a set of criteria that filters out all but the companies that merit a closer look.

Screening criteria fall into five categories:Growth, Profitability, Pricing, risks, liquidity.

In Emerging Markets, the most important screening is growth.

Forcloser look at individual stocks, most investors use several approaches, depending on the availability and reliability of information available.

The key approaches include the following:

(i)Discounted Cash Flow Models :

Value is calculated asfuture free cash flows discounted by the weighted average cost of capital.

In order to estimate future cash flows:

Financial statements must be analyzed and adjusted to reflect international accounting standards.This can be a major task.

Future estimates of profits normally require a good market/marketing analysis and analysis of competitors.

Normally, cash flows for the first two years are calculated in detail, individually.For years two to five, a company-specify growth rate of expected cash flows is estimated.After year five, it is assumed that the rate of growth of the companys cash flows will revert to the average for similar firms in the market.

The weighted average cost of capital is estimated using local information.

(ii)Asset-Based Valuation Models :

(a) Liquidation Value:Sale value minus debts

(b) Replacement Value: with/without technology changes.

But ignores going concern, intangibles, human capital.

(iii)Comparator Valuation Models :

(a) Price/Earnings Ratios:P/E ratio of comparable firms in the country, times the earnings per share of this company. Earnings are normally reported as EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization): This facilitates comparisons of fundamental profitability among firms, as iteliminates the effects of financing and accounting decisions .

(b) Market-to-Book Ratios: MV/B ratio for comparable firms times the book value of this company.

Discounted Cash Flow models are better predictors of value than the other approaches, but in EMs,the information is harder to get.

P/E ratios work better in stable situations.In Emerging Markets, both prices and earnings are quite unstable, with P/E ratios changing substantially in short periods of time.

In addition to valuation methods, most EM investors use more strategic considerations for stock selection, including the following:

(1)Competitive Advantage :Is there a Niche for this company.Does it have a recognized name? Does it posses consumer loyalty?

(2) Large Market Share .Well-managed companies in EMs tend to consolidate and increase market share.

(3)Good Management .This is a key factor. Investors look at the training, experience of senior managers.

(4)Strategic Relationships .Does the company have foreign investors?Does it have technology agreements with firms abroad?

(5)Export Orientation .Is a good portion of revenues from exports?

(6)Hidden Assets .In EMs, many companies have hidden assets that may be substantially under-priced.

(7)Other Shareholders .Who they are and their influence in the country

Date post:	22-Jan-2015
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Lecture 5: Emerging Stock Markets. Dr. Edilberto Segura

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