8.5 Emerging market financial instruments
7 min read•august 19, 2024
Emerging market financial instruments offer unique opportunities and risks for investors. These include stocks, bonds, currencies, and derivatives from developing economies, often providing higher potential returns but with increased volatility and political risks.
Investing in emerging markets requires careful consideration of currency exchange, liquidity, and economic factors. While these instruments can offer benefits, they also come with challenges in valuation, accounting, and taxation that investors must navigate.
Types of emerging market instruments
- Emerging market instruments encompass a wide range of financial assets from developing economies, offering investors unique opportunities for growth and diversification
- These instruments include equities (stocks), bonds (government and corporate debt), currencies, and derivatives (such as swaps and options)
- Emerging market instruments often exhibit higher potential returns compared to developed market counterparts, but also come with increased risks due to factors like political instability, currency fluctuations, and liquidity constraints
Risks of emerging market investing
Currency exchange risks
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- Investing in emerging market instruments exposes investors to currency exchange risks, as the value of the local currency can fluctuate significantly against the investor's home currency
- Depreciation of the emerging market currency can erode the returns earned on investments, even if the underlying assets perform well in local currency terms
- Investors can mitigate currency exchange risks through strategies, such as using currency forwards or options to lock in exchange rates
Political and economic risks
- Emerging markets are often characterized by less stable political environments, with potential for regime changes, social unrest, or policy shifts that can impact financial markets
- Economic risks in emerging markets include high inflation rates, balance of payment issues, and vulnerability to external shocks (commodity price swings)
- Investors need to carefully assess the political and economic landscape of an emerging market before investing, and monitor developments over time
Liquidity risks
- Emerging market instruments may have lower trading volumes and less developed market infrastructure compared to developed markets, leading to liquidity risks
- In times of market stress, investors may face difficulties selling their emerging market holdings at fair prices or in a timely manner
- Liquidity risks can be mitigated by focusing on larger, more established emerging market securities and using limit orders when trading
Emerging market equities
Characteristics of emerging market stocks
- Emerging market stocks represent ownership in companies based in developing economies, offering exposure to the growth potential of these markets
- These stocks often have lower market capitalizations and trading volumes compared to developed market counterparts
- Emerging market stocks may exhibit higher volatility due to the underlying political, economic, and currency risks
Emerging market stock indexes
- Emerging market stock indexes, such as the MSCI Emerging Markets Index, provide benchmarks for the performance of emerging market equities as a whole
- These indexes are often used as the basis for passive investment products like index mutual funds and exchange-traded funds (ETFs)
- Key emerging market stock indexes cover a diverse range of countries (China, India, Brazil) and sectors (technology, financial services, consumer goods)
Emerging market bonds
Government bonds in emerging markets
- Emerging market government bonds are debt securities issued by the national governments of developing countries, typically denominated in the local currency or major global currencies (US Dollar)
- These bonds offer investors the opportunity to earn higher yields compared to developed market government debt, but also carry increased credit risk due to the potential for default or restructuring
- Investors can access emerging market government bonds through individual securities, mutual funds, or ETFs
Corporate bonds in emerging markets
- Emerging market corporate bonds are debt securities issued by companies based in developing economies, allowing investors to gain exposure to the growth of the private sector in these markets
- Corporate bonds in emerging markets often have higher yields than their developed market counterparts, reflecting the increased credit risk associated with these issuers
- Investors should assess the creditworthiness of individual issuers and consider diversifying across multiple bonds to manage risk
Emerging market currencies
Currency carry trades
- Currency carry trades involve borrowing in a low-yielding currency and investing in a higher-yielding currency, aiming to profit from the interest rate differential
- Emerging market currencies often offer higher interest rates compared to developed market currencies, making them attractive targets for carry trades
- Carry trades are subject to currency exchange risks, as a sudden depreciation in the emerging market currency can quickly erase any interest rate gains
Hedging emerging market currency risk
- Investors can hedge emerging market using derivatives such as currency forwards, futures, or options
- Hedging strategies aim to reduce the impact of currency fluctuations on investment returns by locking in exchange rates or limiting downside risk
- Investors should consider the costs and complexity of hedging strategies, as well as the potential for reduced upside potential when currency movements are favorable
Emerging market derivatives
Credit default swaps in emerging markets
- Credit default swaps (CDS) are derivatives that provide insurance against the default of an emerging market bond issuer, allowing investors to manage credit risk
- In a CDS, the buyer makes periodic payments to the seller in exchange for a contingent payment if a default event occurs
- CDS can be used to hedge existing bond positions or to gain exposure to emerging market credit risk without owning the underlying bonds
Interest rate swaps in emerging markets
- Interest rate swaps are derivatives that allow investors to exchange fixed-rate payments for floating-rate payments (or vice versa) based on an emerging market interest rate benchmark
- These swaps can be used to manage interest rate risk in emerging market bond portfolios or to speculate on changes in emerging market interest rates
- Interest rate swaps are subject to counterparty risk, as the failure of one party to meet its obligations can result in losses for the other party
Emerging market ETFs and mutual funds
Advantages vs individual securities
- Emerging market ETFs and mutual funds offer investors a convenient way to gain diversified exposure to emerging market instruments, without the need to select and manage individual securities
- These funds can provide access to a broad range of countries, sectors, and asset classes, helping to mitigate the risks associated with individual emerging market investments
- Professional fund managers can leverage their expertise and resources to identify attractive emerging market opportunities and manage portfolio risks
Actively managed vs index funds
- Actively managed emerging market funds aim to outperform a benchmark index by selecting securities based on the fund manager's analysis and judgment
- Index funds, such as those tracking the MSCI Emerging Markets Index, seek to replicate the performance of a benchmark by holding a similar composition of securities
- Investors should consider factors such as fees, historical performance, and investment style when choosing between actively managed and index funds in the emerging markets space
Accounting for emerging market instruments
Fair value measurements
- Emerging market instruments are typically measured at fair value on the balance sheet, with changes in fair value recognized in the income statement or other comprehensive income
- Fair value is determined based on quoted market prices for identical or similar instruments, or through valuation models that incorporate observable and unobservable inputs
- Valuation models for emerging market instruments may require significant judgment and estimates, particularly for illiquid or complex securities
Foreign currency translation adjustments
- Investments in emerging market instruments denominated in foreign currencies are subject to foreign currency translation adjustments when preparing financial statements
- These adjustments reflect the changes in exchange rates between the functional currency of the reporting entity and the currency of the emerging market instrument
- Foreign currency translation adjustments are typically recognized in other comprehensive income and can introduce volatility to the balance sheet and equity accounts
Tax considerations for emerging markets
Withholding taxes on dividends and interest
- Dividends and interest income from emerging market instruments may be subject to withholding taxes imposed by the local jurisdiction
- Withholding tax rates vary by country and may be reduced or eliminated under tax treaties between the investor's home country and the emerging market jurisdiction
- Investors should consider the impact of withholding taxes on their after-tax returns and explore opportunities for tax relief or recovery
Capital gains tax treatment
- Capital gains realized on the sale of emerging market instruments may be subject to taxation in the investor's home country and/or the emerging market jurisdiction
- The tax treatment of capital gains can vary depending on factors such as the holding period, the type of instrument, and the investor's tax residency status
- Investors should consult with tax professionals to understand the capital gains tax implications of their emerging market investments and to develop tax-efficient investment strategies
Emerging markets vs developed markets
Return potential and volatility
- Emerging markets have historically offered higher average returns compared to developed markets, reflecting the growth potential and risk premiums associated with these economies
- However, emerging markets also tend to exhibit higher volatility than developed markets, with more frequent and pronounced market movements
- Investors should weigh the potential for higher returns against the increased volatility and risks when allocating to emerging markets
Correlation benefits for diversification
- Emerging markets tend to have lower correlations with developed markets, meaning that their performance is less likely to move in lockstep with developed market assets
- This lower correlation can provide diversification benefits for investors, as the inclusion of emerging market instruments may help to reduce overall portfolio risk
- However, correlations between emerging and developed markets can increase during periods of global market stress, reducing the diversification benefits
Key Terms to Review (18)
Basel III: Basel III is a global regulatory framework established to strengthen the regulation, supervision, and risk management within the banking sector. It was developed by the Basel Committee on Banking Supervision and focuses on improving the banking sector's ability to absorb shocks arising from financial and economic stress, enhancing risk management, and promoting transparency. This framework has significant implications for emerging market financial instruments and cross-border debt and equity financing, as it sets higher capital requirements and introduces liquidity standards that banks must adhere to when operating internationally.
Comparative Valuation: Comparative valuation is a financial analysis method that involves assessing the value of an asset by comparing it to similar assets in the market. This technique helps investors and analysts determine whether an asset is overvalued or undervalued relative to its peers, taking into account factors such as financial performance, market conditions, and risk profiles. By utilizing this approach, one can make informed investment decisions, especially in emerging markets where data may be limited and valuations can vary widely.
Convertible Debt: Convertible debt is a type of bond or loan that can be converted into a predetermined number of shares of the issuing company's stock, usually at the discretion of the bondholder. This financial instrument allows investors to enjoy the benefits of fixed income while also having the potential for equity participation in the company if its stock performs well. The unique feature of convertible debt makes it an attractive option in emerging markets where companies may seek flexible financing solutions.
Currency risk: Currency risk refers to the potential for financial loss due to fluctuations in exchange rates when conducting transactions in different currencies. This risk is particularly significant for businesses and investors involved in international markets, as changes in currency values can impact profitability, asset valuations, and financial reporting. Managing currency risk is essential for effective financial planning and can involve strategies such as hedging, diversification, and careful analysis of foreign market conditions.
Discounted cash flow: Discounted cash flow (DCF) is a financial valuation method used to estimate the value of an investment based on its expected future cash flows, which are adjusted to reflect their present value. This method is critical in assessing investments, especially in an international context where currency risks and economic factors can affect cash flows, and in evaluating emerging market financial instruments that often have uncertain cash flow patterns. By considering the time value of money, DCF allows investors to make informed decisions about potential returns on investments.
Diversification: Diversification is the strategy of spreading investments across various financial instruments, industries, or other categories to reduce risk. By not putting all eggs in one basket, diversification aims to minimize the impact of any single asset's poor performance on the overall portfolio. This strategy becomes particularly relevant in emerging markets where investments can be more volatile and unpredictable.
GAAP: GAAP, or Generally Accepted Accounting Principles, refers to a collection of commonly followed accounting rules and standards for financial reporting. These principles provide a framework that ensures consistency, transparency, and comparability in the financial statements of companies, making it easier for investors and stakeholders to analyze financial data across different organizations.
Gdp growth rate: The GDP growth rate measures how quickly a country's economy is growing by comparing the Gross Domestic Product (GDP) of one period to that of another. This rate is essential for understanding the overall economic health of a nation, influencing investment decisions and economic policies, and can indicate levels of country risk and investment potential, particularly in emerging markets.
Hedging: Hedging is a risk management strategy used to offset potential losses in investments or financial transactions by taking an opposite position in a related asset. This approach helps protect against adverse price movements, allowing individuals and organizations to stabilize their financial outcomes. By employing derivatives, such as options and futures contracts, participants can create a safety net against fluctuations in markets or currencies, thereby minimizing exposure to volatility.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that provide a global framework for financial reporting. These standards aim to bring consistency, transparency, and comparability to financial statements across different countries and industries, making it easier for investors and stakeholders to understand and analyze financial information.
IFRS for SMEs: IFRS for SMEs is a set of international accounting standards specifically designed for small and medium-sized enterprises, providing a simplified and cost-effective framework for financial reporting. This set of standards aims to enhance the comparability and transparency of financial statements of SMEs, enabling them to better access capital markets and improve their business operations. By focusing on the unique needs and challenges faced by smaller businesses, these standards facilitate better financial management and increase the reliability of financial information.
Inflation rate: The inflation rate is the percentage increase in the price level of goods and services in an economy over a specific period, usually measured annually. Understanding inflation is crucial because it affects purchasing power, investment decisions, and economic stability. It plays a significant role in financial analyses across different countries, as varying inflation rates can impact comparative performance metrics. Additionally, assessing country risk involves examining inflation rates since high inflation can signal instability and affect the attractiveness of investments in emerging markets.
Local currency bonds: Local currency bonds are debt securities issued in the domestic currency of the issuing country, allowing investors to lend money to governments or corporations while minimizing foreign exchange risk. These bonds play a crucial role in emerging markets by providing a means for local entities to raise capital while also attracting foreign investors who seek exposure to the local economy without the added volatility of currency fluctuations.
Momentum trading: Momentum trading is an investment strategy that aims to capitalize on the continuation of existing market trends by buying securities that are rising and selling those that are falling. This strategy is based on the belief that stocks that have performed well in the past will continue to do well in the future, while those that have performed poorly will continue to underperform. In the context of emerging markets, momentum trading can offer unique opportunities and risks, as these markets often exhibit greater volatility and price fluctuations.
Political Risk: Political risk refers to the potential for losses or negative impacts on an investment or business operations due to political changes or instability in a country. This can include changes in government, shifts in political power, civil unrest, and changes in laws or regulations. Understanding political risk is crucial for investors and businesses operating in international markets, as it can significantly affect financial performance and strategic decisions.
Private equity firms: Private equity firms are investment management companies that provide capital to private companies or acquire public companies with the intent to delist them from stock exchanges. These firms raise funds from institutional investors and high-net-worth individuals, focusing on investing in underperforming or undervalued companies to improve their performance and ultimately generate a profit upon exit, often through a sale or initial public offering (IPO). Their investment strategies can significantly impact emerging markets by providing growth capital and improving corporate governance.
Sovereign Wealth Funds: Sovereign wealth funds are state-owned investment funds or entities that manage a country's reserves for the purpose of generating returns on investment. They are typically funded by surplus revenues from natural resources, foreign exchange reserves, or fiscal surpluses and play a crucial role in emerging markets by providing capital for development and stability in financial systems.
Value investing: Value investing is an investment strategy that involves picking stocks that appear to be undervalued in the market. This approach focuses on identifying securities whose prices do not reflect their intrinsic value, often due to temporary market inefficiencies or investor behavior. Value investors believe that by purchasing these undervalued stocks, they can achieve higher returns when the market eventually corrects itself.