Portfolio Analysis of Major Eastern European Stock Markets

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ABSTRACT

The objective of this paper is to examine the investment opportunities presented by the newly emergent stock markets of Eastern Europe from the perspective of a US investor who invests solely in the US markets. An optimal investment strategy is derived for the stock markets of a select group of Eastern European countries: the Czech Republic, Hungary, and Poland. It appraises the risks and rewards of investing in these countries based on market volatility as well as both foreign exchange and sovereign risks. It is shown that the derived optimal portfolio provides a risk-adjusted return that either surpasses or equals the return realizable from investing in stock markets with lesser degrees of risk. The optimal portfolio is calculated based on daily stock-market returns for the emerging Eastern European countries, with the S&P 500 Index incorporated into the analysis. The portfolio's performance is evaluated using portfolio evaluation criteria.

JEL classification: C44, C52, C61, D81, D9, F3, G1, N2, P3

Keywords: Stock Market; Eastern Europe; Czech Republic; Hungary; Poland; Stock returns; Portfolio diversification; Lower-partial moments; Variance-covariance analysis; portfolio-evaluation measures; Reward to semi-variance; First, second and third degree stochastic dominance; Quadratic-programming analysis

I. INTRODUCTION

In 1993, the Warsaw Stock Exchange rose 800% in United States dollars and set a new-world record. This paper provides an analysis of the risk return trade-off of investing in newly emerging Eastern European stock markets such as Poland, as well as Hungary and the Czech Republic. (1) An optimal portfolio is derived based on historic observations, and then evaluated utilizing reliable performance measures. In the end, to the dismay of those wishing to profit from the Eastern European markets, the results show this investment decision to be a far less grandiose prospect than originally conceived. Investors should invest at most up to 2% of their stock portfolio in these markets.

The most dramatic changes in Eastern Europe are associated with stock market developments in the Czech Republic, Hungary, and Poland. The opening of these markets has attracted both foreign investors and foreign financial institutions. The entrepreneurial private investor now plays an increasingly important role and is strongly being encouraged to enter the markets. Such developments have created the need for collection and dissemination of current, accurate data. The doors have opened to privatization acquisition and joint ventures accompanied with repatriation of earnings. At the same time, state enterprises are undergoing major changes. Some state enterprises have been dismantled while others are being reconfigured as holding companies with the injection of new government capital, or split into separate companies that may be viable. Still others have been completely liquidated. It has been said that in no place in the world has there been so dramatic a shift in both culture and economic institutions. As economic restructuring takes place, studying the performance of these Eastern European stock markets is a worthwhile undertaking. The Czech Republic, Hungary, and Poland have attracted attention from potential Western investors because of their willingness to accept economic change and their apparent determination to pursue systematic structural reforms. Subsequent to the creation of the new Czech Republic in January 1993, (2) The Prague Stock Exchange opened in April 1993 and presently has 10 listed issues and 976 unlisted issues. (3) Foreign direct investment, with the notable exception of Volkswagen in the Skoda enterprise, has generally been small, and usually made by Czechs living abroad. (4)

Of the three markets in this study, Hungary has been the prime location in Eastern Europe for Western investment, and as a result, it has been the largest recipient of foreign capital in Eastern Europe. …