Measuring risk for investment in emerging markets

Abstract

The developing countries or emerging economies have recently attracted a lot of attention from investors in the developed countries. With opportunities in the developed financial markets drying up, the emerging economies provide an investment destination with high returns. However, caution must be observed while investing in these economies, as the rewards might not be commensurate with the risks taken. We have come up with two approaches to measure investment risk in emerging markets. In the first approach we define two kinds of risks; international (currency rate) risk and local business (systemic) risk. We identify the most attractive country to invest from the point of view of 3 different developed countries (USA, UK and Japan) based on reward to risk ratios in respect of both these risks. While many models exist to determine the ideal market for investment, the authors believe that none of these models incorporate both the international risk, which comes from the exchange rates and interest rate differentials, and the local business risk that is inherent to the economy where investments are being made. We attempt to analyze the rewards available from undertaking both these kinds of risks and try to find the most attractive investment location. This is done for pairs of investing country and the destination country, the argument being that a specific emerging market might be attractive to investors in a particular country but not to those in another country. Based on the above model, we look at different emerging markets and predict their attractiveness to investors in different countries. This model can be a useful tool to isolate reward to systematic risk characteristics for a multinational company that is looking for preliminary selection or elimination of countries as target investment locations. The authors believe that since both risks have been considered in the model, this framework is more robust and reliable than any other existing frameworks. In the second approach, we analytically quantify the currency risk (in terms of a currency beta) faced by a foreign investor in Indian stocks and then empirically determine it for 43 companies in India.