What are “Emerging Markets?”

The term “emerging markets” refers to a set of countries that are transitioning from the developing to the developed stage. These markets are characterized by high rates of growth but typically also have higher market volatility relative to developed markets. In terms of economic performance, emerging markets usually have some but not all of the traits of a developed market economy. They are typically in the process of creating an infrastructure to support the high growth.

Emerging markets tend to attract foreign investors, due to their relatively high return on investment, and growth potential relative to developed economies. There are also greater opportunities for diversification vis-à-vis investment portfolios. The largest emerging markets in the world are currently: China, India, Brazil, Russia and South Africa.

There are varying ways to categorize emerging markets – the MSCI Emerging Market Index includes 27 emerging market economies across the Americas, EMEA and Asia. This index is heavily weighted towards China, South Korea, Taiwan and India. The IMF counts 23 countries as emerging, as does S&P. Emerging markets tend to have higher growth rates than developed economies, which in turn leads to rapid expansion of corporate profits. Consequently, their stock markets also expand in value.

Key Learning Points

  • Emerging markets are transitioning towards becoming developed markets
  • They typically have some but not all of the characteristics of a developed market
  • While investing in emerging markets offers several potential benefits, there are several important risks involved, which are termed as ‘Country Risk’
  • Due to the additional risks involved in investing in emerging markets, they demand a higher return or premium known as ‘Country Risk Premium (CRP),’ which enhances the cost of equity
  • To derive equity risk premium, we need to include CRP in CAPM

Emerging Markets – Risks, Country Risk Premium and Cost of Equity

Investing in emerging markets offers several potential benefits that include investment diversification (to mitigate investment risk), the potential to improve a portfolio’s overall long-term returns and the opportunity for active fund managers to identify stocks that are trading at valuations that are inexpensive or cheap relative to their respective growth outlook.

The investment objective of emerging market equity funds is typically long-term growth. They are usually seeking long-term capital appreciation. There are three broad types of emerging market equity funds – Active EM equity funds, Ishares EM ETFs and global region-country specific funds.

Investing in emerging markets exposes investors to additional risks (detailed below). Consequently, investing in emerging markets is generally riskier than developed markets.

Country risk – these risks vis-à-vis emerging markets include: political instability, economic risk, higher inflation, less developed regulatory and legal framework, inability to repatriate earnings, geo-political risks, interest rate risk, liquidity risk, large swings in commodity prices, economic uncertainty and market performance, exchange rate volatility or fluctuation, risk of expropriation of assets, lack of transparency in financial markets, sovereign debt burden, probability of default etc. Such risks are collectively termed as “Country Risk”

Given the additional investment risks of emerging markets, investors generally demand a higher return or a premium to invest in such markets. This is termed “Country Risk Premium (CRP),” which tends to be higher for emerging markets than for developed markets. The CRP is a key consideration for investors investing in overseas or emerging markets. It is very useful to quantify the expectations of investors of higher returns for investments in emerging markets, which are riskier than developed economies.

The country risk premium for an emerging market (for example, Country L) can be calculated as:

CRP = (Spread on sovereign debt yield of Country L) * (annualized standard deviation of the stock market index of Country L/annualized standard deviation of the sovereign bond market or index of Country L).

The spread on sovereign debt yield of Country L = the yield on Country’s L’s USD denominated sovereign bond (10-year bond) – yield on 10-year US Treasury bond.

The annualized standard deviation is a measure of volatility.

Next, to derive the equity risk premium vis-à-vis emerging markets, that can be used to assess the risk of investing in a company in such markets, we need to include CRP in the CAPM formula (which states the relationship between systematic risk and expected return, particularly for stocks).

Stated below is the CAPM Model – incorporating the CRP, which is used to calculate the cost of equity.

Ke = Rf + Bp * (Rm – Rf + CRP)

Ke = cost of equity

Rf = Risk free rate

Bp = Beta of an investment

Erm = relates to expected return in the market

(ERm – Rf) = Risk Premium for taking on equity risk

CRP = Country Risk Premium

Emerging Markets – CRP and Cost of Equity

Given below is an example, where the CRP and the cost of equity has been calculated. The equity risk premium has been computed for an emerging market economy (Country L). One can notice from the calculations below that the CRP has significantly increased the cost of equity.