A Comparison of the Risk and Return Characteristics of Developed and Emerging Stock Markets

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ABSTRACT

Finance theory suggests that the higher volatility typically associated with emerging stock market returns translates into higher expected returns in those markets. This paper compares the risk and return profile of emerging and developed stock markets over the period from 1994 through 2001. Specifically, this study investigates, from a U.S. investor's point of view, whether a measurable difference in risk characteristics exists between the two markets and whether the realized rates of return in these two types of markets reflect these risk characteristics. The results show that the risk associated with emerging markets, as measured by the volatility of returns, is notably higher than the risk in developed markets in most periods. However, the returns in emerging markets have been notably lower than those in developed markets for most of the time frames examined. The findings suggest that risk-averse investors seeking higher returns in volatile emerging markets have not been well-compensated for assuming the higher risk associated with these markets.

INTRODUCTION

The literature makes a distinction between developed and emerging stock markets based on their differing characteristics. The world's developed stock markets are generally assumed to be more liquid and efficient compared to their counterparts in emerging countries. Finance theory suggests that the higher volatility typically associated with emerging stock market returns translates into higher expected returns in those markets. While many stock markets underwent considerable evolution during the last decade, emerging markets, in particular, grew exponentionally in terms of trading volume, number of listed companies, and market capitalization (Goetzmann & Jorion, 1999). In recent years, attractive prospects in these markets have renewed the interest of global investors (Domowitz et al., 1997; Richards, 1996; Erb et al., 1997; Bekaert et al., 1997). Although there is some evidence to suggest that many emerging markets are becoming more integrated into the global capital market (Bekaert & Harvey, 1995), overall, these markets still differ from developed markets in their high liquidity risk and limited availability of high quality, large capitalization shares.

The literature provides plenty of evidence suggesting the existence of higher volatility and price changes in emerging stock markets (Salomons & Grootveld, 2003; Appiah-Kusi & Menyah, 2003; Harvey et al., 2000; Kawakatsu & Morey, 1999; Bekaert et al., 1998; Bekaert & Harvey, 1997; De Santis & Imrohoroglu, 1997; Bekaert et al., 1997; Schaller & Van Norden, 1997). Also, compared to developed markets, common characteristics of emerging markets include a high degree of country risk (i.e., political risk, economic risk, and financial risk), currency devaluations, failed economic plans, financial shocks, and capital market reforms. Thus, the higher degree of risk typically associated with emerging markets suggests a higher expected rate of return in these markets. However, some researchers (Harvey, 1995; Bekaert, 1995) suggest the opposite to be true. Therefore, the main motivation for this research is to investigate (a) whether emerging market returns are exposed to more volatility compared to those of their more developed counterparts, (b) how the realized rates of return in the two types of markets compare to each other, (c) whether there exists a measurable difference in risk characteristics between the two types of markets, and (d) how consistent these results are over the period from 1994 through the end of 2001. The year 1994 was selected as a starting point for the comparison since that is the first year where the returns for a sufficiently large number of emerging market countries was reported with any consistency.

The remainder of this paper is organized as follows: Section II discusses the data and methodology, which is followed by the findings, which are discussed in Section III. …

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