Stability, Volatility, Risk Premiums, and Predictability in Latin American Emerging Stock Markets
Haque, Mahfuzul, Hassan, M. Kabir, Varela, Oscar, Quarterly Journal of Business and Economics
Emerging markets' equity flows have increased recently, with market capitalization growing at nearly double the rate of the world's equity market. Latin America's emerging equity markets have concurrently experienced numerous changes, some in economic policy. For example. Mexico suffered economic crises with the peso collapse in 1994, just two years after NAFTA. In 1991 Argentina changed its currency policy, assigning one Argentine peso a value equal to one U.S. dollar, with Brazil following in 1994. Privatization of state-owned enterprises have occurred, economic stabilization programs have been enacted, and these markets have opened to foreign investments at unprecedented levels, with foreign portfolio capital pouring into the region and its market size growing rapidly. The environment in Latin America now involves policies that are more market leaning with corporate sector restructuring. These events over the past decade demand continued research into the performance of the Latin American stock markets, fo r their ability to transfer saving into investment has major implications for the region's growth and development.
This paper examines, within the context of this environment, the stability, volatility, risk premiums, and persistence of volatility in the 1988-98 exchange-converted U.S. dollar equity returns of Argentina, Brazil, Chile, Columbia, Mexico, Peru, Venezuela, and the Latin America (LA) index. It also examines these markets' predictability, using U.S. dollars and local currency returns, to test the robustness of predictions. This study uses a battery of statistical methods and a relatively large sample of Latin American countries, unlike previous studies usually limited to a smaller set or a single country. It aims to examine these emerging markets robustly, as understanding the performance of these markets is important to portfolio managers and policy makers alike.
In general, coefficient stability for Box-Jenkins ARMA representations of weekly returns, volatility effects of expected returns in GARCH frameworks, and the predictability of equity returns are examined. The findings suggest that Latin American emerging markets have shown remarkable performance using return to risk measures, have volatility clustering with shocks that decay with time, and are mixed in terms of predictability.
Returns, volatility and correlations, and the clustering, persistence, and forecastability of volatility are the subject of this review, in accord with the application of these to Latin America's emerging markets. (1)
Expected returns in emerging markets can be impressive at times, but are highly volatile. Barry and Rodriguez (1997) find that the risk and return performance in Latin America's equity market has been among the most volatile in the world. Generally, the literature documents low correlations between emerging and developed market returns, creating a basis for diversification benefits owing to risk reductions associated with international portfolios involving emerging and developed markets. (2) Gooptu (1993) finds increasing equity flows to developing countries.
Risk and return relationships can be unclear across time periods, leading to more volatility. Normally, returns and risk premiums are directly related to the asset's variance and covariance with the market portfolio (Sharpe, 1964; Lintner, 1965; Mossin, 1966; and Black and Scholes, 1974). Glosten, Jagannathan, and Runkle (1993), however, claim that across time periods there is no agreement about the relation between risk and return. Investors may not demand a high-risk premium if the risky time periods coincide with periods when investors, better able to bear risk, are less risk averse. A riskier expected future may motivate investors to save more now, lowering the premia. (3)
Volatility clustering has a long history as a salient empirical regularity characterizing highly speculative prices, but not until recently has the importance of explicitly modeling time-varying second order moments been recognized. …