Question

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 OECD. Its annual inflation rate is around 10%, well above the average inflation rate of developed countries estimated at 2% by the OECD. 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?   
3. Suggest why you would consider investing in this emerging country.

Answer 1

a. High inflation and a weak currency are only a few of the many indicators whether the investment is to be done or not. These are not the sole indicators on which decisions can be taken. Many emerging economies have high inflation rate, this may be due to the high growth that emerging countries exhibit. Inflation within certain limits is healthy for the economy. Also, there can be various reasons for a weak currency. Import driven economies generally have weaker currencies. However, these are not sufficient reasons to avoid investing.

b. No, high volatility is not a sufficient reason to avoid investing. However, high volatility does raise some alarms and the reason for the high volatility must be investigated. If the high volatility is accompanied by higher returns and an appropriate correlation with the rest of one's portfolio, then the investment can be considered good to hold.

c. The emerging countries is a high return high volatile investment. However, the correlation of this emerging stock market with the World index is only 0.2. Investing in this country would ensure that the benefits of diversification are reaped and when the investment is combined with other investments, the overall risk factor would reduce due to the lower correlation.