Currency Risk in Emerging Equity Markets

A model for pricing risk in liberalising economies.

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254882_chinese_lucky_catThe recent emergence of highly remunerative equity markets, following the relaxation of foreign investment restrictions, and the developments in communication and trading systems, has attracted on the one hand, the attention of academics to explain their impressive returns, and on the other hand, the interest of international fund managers as opportunities for portfolio diversification benefits. The adoption of more flexible exchange rate regimes by many emerging economies however in the late eighties and early nineties is likely to have affected the foreign currency risk associated with international investment and to have made the choice of currency denomination an important element in the overall portfolio decision.

The objective of this paper is to develop an international capital asset pricing model, which includes currency risk, and to examine the impact of capital market liberalisation on the pricing of risks. Previous capital asset pricing models can be classified into three groups based on the type of risk considered in pricing expected returns: segmented market models, which evaluate expected equity returns as a function of only the country-specific risk represented by stock returns variance (see e.g. Black, 1972); the integrated market models where studies assume that all the world capital markets are perfectly integrated, and therefore the source of their risk can be associated with the covariance of the local stock market returns with the world market portfolio (see e.g. Ferson and Harvey, 1994); and the partially segmented market models, which considered an asset pricing model, where the framework in which the polar segmented/integrated cases are replaced by a mild segmentation structure (see Errunza, Losq, and Padmanabhan, 1992). While this model presents the advantage of avoiding the choice between the scenario of full segmentation and perfect integration, the framework has the disadvantage of selecting a degree of segmentation that is fixed through time. Read the full paper here or join the debate to participate in an interactive forum on the ins and outs of currency hedging.

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