Question

Question 3                                                                                                      

You are thinking to invest in some emerging country. Its recent economic growth rate is around 7%, well above the average growth rate of developed countries estimated at 2% by the IMF. Its annual inflation rate is around 10%, well above the average inflation rate of developed countries estimated at 2% by the IMF. The currency of the emerging country has been depreciating at an annual rate of around 8% against major currencies. While the volatility of the World stock index (standard deviation of dollar returns) is around 15%, the stock market of this emerging country has a volatility of 25%. The correlation of this emerging stock market with the World index is only 0.2.

1. Are the high inflation rate and weak currency sufficient reasons to avoid investing in this emerging country?                                                                                                    
2. Is the high volatility of the local market a sufficient reason to avoid investing in this emerging country?                                                                                                              

Suggest why you would consider investing in this emerging country.              

Answer 1

a. Are the high inflation rate and weak currency sufficient reasons to avoid investing in this emerging country?

No. Emerging economies naturally have to run higher inflation rates as they catch up with the developed world. In fact currency and money markets, rising inflation can have an appeal, as the resulting higher interest rates provide a greater yield on investments, particularly in economies that have shown greater resilience to the global economic crisis and where demand has picked up more quickly.

Emerging economies have the added advantage of being buoyed by growing affluence and a strong local savings pool.Owing to their comparatively less mature capital markets, emerging economies were also better protected from the subprime meltdown and the ensuing credit crunch.

Therefore high inflation rate and weak currency are not sufficient reasons to avoid investing in emerging country.

b. Is the high volatility of the local market a sufficient reason to avoid investing in this emerging country?    

No. Investment in emerging countries should be for long term. If, however, investors have a long time horizon and can stomach the volatility, then emerging markets would be expected to pay returns well in excess of developed market equities in the coming decades. Investors with longer time horizons shouldn’t be deterred. As the economic engine shifts and capital markets develop in tandem, emerging markets would be expected to offer returns in excess of the developed world.

Therefore high volatility of the local market is not sufficient reason to avoid investing in emerging country.

Suggest why you would consider investing in this emerging country.

1. Emerging countries offer to provide new investment opportunities

2. They provide higher returns

3. Investing in emerging countries provide benefits of diversification

4. The current valuation of emerging markets, as measured by the Price to Book ratio, is much more attractive than that on offer in developed markets

5. For many investors, emerging markets became a core part of their portfolios because they offered strong returns and faster growth as the emerging world caught up.