On Risk and Return in MENA Capital Markets
Girard, Eric, Omran, Mohamed, Zaher, Tarek, International Journal of Business
This paper investigates relationships between market risk premium, time-varying variance and time-varying covariance in eleven Middle Eastern and North African (MENA) markets and eight developed markets from 1990 to 2001. Following Pettengill, Sundaram and Mathur (1995), we argue that the Capital Asset Pricing Model has only been partially examined because the negative portion of the market risk premium distribution has not been priory fully investigated. This issue is addressed by implementing a state-dependent multivariate GARCH methodology to proxy for a risk-return relationship. As a result, significant positive and negative relationships between risk premiums and conditional variance (covariance) are found in MENA capital markets (developed markets). We conclude that MENA markets are highly segmented and provide diversification benefits to the global investor. We test for asymmetric patterns of reward to risk and observe that six out of the eleven MENA markets return series exhibit overly pessimistic reactions unwarranted by market variance alone. This finding supports the overreaction hypothesis and sets grounds for contrarian portfolio strategies.
JEL: G12; G15
Keywords: CAPM; Conditional risk; Market price of risk; Overreaction hypothesis; MENA markets.
The Middle-Eastern and North African region (MENA) has recently witnessed significant economic and financial development. However, MENA countries' trade and capital flow remain marginal on a global level. Additionally, risk perceptions and institutional underdevelopment are powerful obstacles to an increased access to MENA capital markets. Many countries in this region have suffered wars, political turmoil or economic instability. Indeed, MENA countries have not yet emerged as economic powers and are rarely referred to as influential countries in the global financial scene, which might explain the lack of academic research on MENA capital markets. The purpose of this paper is to fill this void in the literature by addressing the issue of risk measurement in eleven MENA markets. The measurement of risk is important because it is the precept for predicting market returns and therefore, the tenet for country selection. Thus, the results of this paper are expected to contribute to the paradigm of asset pricing in emerging markets and, more generally, global asset allocation strategies.
Traditionally, the boundaries of the Middle East consist of all countries in an area extending from the Atlantic Ocean in the West to the Persian Gulf in the East and bound by the Mediterranean, Europe and Asia in the North, and the Sahara in the South. Most MENA capital markets are considered as "emerging" according to the World Bank (1). Research on emerging markets shows that capital markets in Asia, Latin America and Eastern Europe are characterized with high returns and volatility, low correlation with the world market, and subject to shocks (Harvey, 1995a, 1995b, 1995c). Findings can be different with MENA equity markets: for instance, Erb, Harvey and Viskanta (1996) find that Egypt and Turkey fit the traditional mold of high returns and volatility, whereas Jordan exhibits typically low return and volatility as compared to industrialized markets.
While MENA markets returns have a low correlation with the world market (Erb et al., 1996), it is unclear whether they respond to economic and political shocks in the same manner as other emerging markets. A low correlation is an indication of market segmentation and, thus diversification potentials to the global investor. However, many MENA countries started successive privatizations, liberalization of foreign ownership, and "anti red tape laws" during the 90s. The effect of country liberalization could affect market sensitivity to local risk factors differently. Indeed, price sensitivity to local variance can either increase as trading volume and capital flight increases, or it can decrease as local markets are less sensitive to local economic shocks and move increasingly in tandem with the world market. …